This post is Part 2 of a series of posts that addresses the impact of recent regulatory developments on the use of limited recourse provisions in futures customer agreements entered into between a futures commission merchant (an “FCM”) and an investment manager on behalf of one or more of the manager’s clients.
In this post, we provide an overview of recent regulatory pronouncements from two divisions of the Commodity Futures Trading Commission (the “CFTC”) and the Joint Audit Committee (the“JAC”) of several large futures exchanges and the National Futures Association that prohibit the use of limited recourse provisions in futures customer agreements.
Part 2: Recent Regulatory Pronouncements from DSIO, DCR and the JAC (I Cannot Guarantee Your Client’s Losses)
As explained in Part 1, many investment managers have negotiated limited recourse provisions into derivatives trading agreements with banks, broker-dealers, and FCMs. From the investment manager’s perspective, these provisions reflect the contractual and commercial reality that the investment manager is only authorized to control (i.e., exercise discretionary authority) over the specified account and assets with respect to which it has been designated as the investment manager. Accordingly, an investment management agreement does not typically authorize the investment manager to encumber or bind assets of a client under the management of another investment manager.
However, the use of limited recourse provisions in futures customer agreements has been effectively prohibited by the following regulatory pronouncements:
- JAC Regulatory Alert #19-03, which was issued by the JAC on May 14, 2019 (the “JAC Alert”);
- CFTC Letter No. 19-17, which was issued by the CFTC’s Division of Swap Dealer and Intermediary Oversight (“DSIO”) and the Division of Clearing and Risk (“DCR”) on July 10, 2019;
- A Statement by the Directors of DSIO and DCR dated September 13, 2019 (the “Directors’ Statement”) concerning the treatment of separate accounts of the same beneficial owner.
The remainder of this post explores each of these regulatory pronouncements in greater detail.
JAC Regulatory Alert #19-03
The JAC is a self-regulatory body for the U.S. futures industry. The membership of the JAC consists of representatives from the National Futures Association and the following ten futures exchanges: CBOE Futures Exchange, CME Group, Eris Exchange, ICE Futures US, Minneapolis Grain Exchange, NASDAQ OMX Futures Exchange, Nodal Exchange, North American Derivatives Exchange, OneChicago LLC, and trueEX LLC. According to the JAC’s website, the committee’s “primary responsibility is to oversee the implementation and functioning of all terms and conditions of the Joint Audit Agreement [i.e., among the JAC members] and to determine the practices and procedures to be followed by each Designated Self-Regulatory Organization in the conduct of regulatory examinations and financial reviews of FCMs.” In furtherance of its primary responsibility, the JAC issues Regulatory Alerts to provide its members and the futures industry with guidance on a wide range of regulatory topics.
In May 2019, the JAC issued Regulatory Alert #19-03, the subject of which was CFTC Regulation 1.56(b) – Prohibition of Guarantee Against Loss. CFTC Regulation 1.56(b) prohibits an FCM (as well as an introducing broker) from “in any way” representing that it will:
- guarantee any person (including a futures customer) against loss;
- limit the loss of any person (including a futures customer) ; or
- not call for or attempt to collect required margin.
The JAC Alert specifically identifies limited recourse provisions in futures customer agreements as being prohibited by CFTC Regulation 1.56(b), and applies the concept to relationships that an FCM has with an investment manager and the manager’s clients:
For clarity, in the case of a separate account of a beneficial owner managed by an asset manager, the FCM must have at all times the absolute right to look to funds in all accounts of the beneficial owner even accounts that are under different control, as well as the right to call the underlying beneficial owner for funds even if beyond the amount the beneficial owner has allocated to the asset manager(s).
Finally, the JAC specifically instructed FCMs to: (1) audit their futures customer agreements to identify agreements that include impermissible limited recourse clauses; and (2) “take immediate corrective action to identify and rectify” any agreements that are not in compliance with CFTC Regulation 1.56(b).
CFTC Letter No. 19-17, as Amplified by the Directors’ Statement
In July 2019, DSIO and DCR issued CFTC Letter No. 19-17, which addressed, in pertinent part, the application of CFTC Regulation 1.56(b) to FCM customer agreements. In this letter, the DSIO specifically stated that:
To address any shortfall [in margin owed to an FCM by the beneficial owner of an account], the FCM must retain the ability to ultimately look to funds in other accounts of the beneficial owner, including accounts that may be under different control, as well as the right to call the beneficial owner for additional funds.
Approximately two months later, in September 2019, the Directors of the DSIO and DCR issued the Directors’ Statement in order to reiterate the point that CFTC Regulation 1.56(b) effectively prohibits the use of limited recourse provisions in futures customer agreements. Additionally, remediation of contractual provisions must be completed by September 15, 2020.
We fully expect [the clearinghouses for futures contracts] and FCMs and their customers will find solutions that satisfy the [CFTC’s] requirements, as clarified in [Letter No. 19-17], by September 15, 2020. We will not be extending the timeline at any point. As such, we encourage DCOs and FCMs and their customers to work together and to rely on their professional advisors as necessary to meet the expectations that we have laid out for them.
In other words, September 15, 2020, is a “drop dead” compliance date for purposes of remediating futures agreements that contain limited recourse provisions.
CFTC Letter No. 19-17 and CFTC Regulation 39.13(g)(8)(iii)
As a final and related item, Letter No. 19-17 also contained no-action relief regarding the application of CFTC Regulation 39.13(g)(8)(iii) to the treatment of separate accounts of the same customer (i.e., the same beneficial owner and client of an investment manager). The staff of the DCR issued the no-action relief in order to address concerns raised in separate letters received by the CFTC’s staff from the Asset Management Group of the Securities Industry and Financial Markets Association (SIFMA-AMG), the Futures Industry Association (FIA), and the Chicago Mercantile Exchange (CME).
As background, CFTC Regulation 39.13(g)(8)(iii) requires derivatives clearing organization (a “DCO,” also commonly referred to as a “clearinghouse”) to require its clearing members to ensure that their customers do not withdraw funds from their accounts with such clearing members unless the net liquidating value plus the margin deposits remaining in the customer’s account after the withdrawal would be sufficient to meet the customer initial margin requirements with respect to the products or portfolios in the customer’s account, which are cleared by the DCO. Pursuant to Letter No. 19-17, the DCR will not recommend that the CFTC take enforcement action against a DCO if the DCO permits its FCM clearing members to treat separate accounts as separate entities for purposes of CFTC Regulation 39.13(g)(8)(iii), subject to the satisfaction of sixteen conditions set forth in the letter.
This no-action relief was time-limited and would “extend until June 30, 2021, in order to provide [the staff of the DCR] with time to recommend, and the [CFTC] time to determine whether to conduct, and if so, to in fact conduct, a rulemaking to implement appropriate relief on a permanent basis.”
Good day. Good tricks or treats? BOO! DR2