Futures and options on futures in which the underlying interests are single securities or narrow-based indices of securities have never seen significant trading volumes in the United States, but they are becoming an increasingly popular means by which U.S. traders are obtaining exposure to foreign equity markets. While trading these products on U.S. exchanges is a relatively straightforward prospect, trading them on foreign exchanges is not straightforward and involves a number of pitfalls.
There has been renewed interest in the U.S. regulatory requirements for trading security futures, as certain widely traded foreign indexes have vacillated between two U.S. regulatory regimes due to changes in the market prices of the underlying securities. This Sidley Update provides a reminder on the current state of play when trading security futures in the United States.
What Is a Security Future?
A security futures contract is an agreement between two parties to purchase or sell a single security or a narrow-based index of securities on a specified future date at an agreed price. Options on security futures may also be traded. Security futures and options on security futures are collectively referred to under U.S. law as security futures products or SFPs. SFPs may be settled through delivery of the underlying security or securities or via payment of cash. In the United States, SFPs must be listed on a regulated exchange. Outside of the United States, SFPs also are generally listed on regulated exchanges, but they are subject to widely differing domestic regulation based on the location of the market.
CFTC-Regulated Broad-Based Security Index Futures
The offer and sale of futures contracts (and options thereon) on broad-based security indices in the United States are regulated exclusively by the Commodity Futures Trading Commission (CFTC). Foreign broad-based security index futures contracts listed on foreign exchanges may not be offered and sold to customers located in the United States without CFTC approval.1 Prior to October 2011, the procedure for approval was for the CFTC’s Office of General Counsel to issue a no-action letter to the non-U.S. exchange on which the SFP was listed.
In October 2011, the process for obtaining CFTC approval of foreign broad-based security index futures contracts changed. The CFTC must now certify that the relevant contract satisfies the requirements set forth in the Commodity Exchange Act (CEA) and the regulations of the CFTC. The CFTC maintains an online list of foreign broad-based security index futures contracts that have been approved, whether via the no-action process or via CFTC certification.
Security Futures Products
By contrast to futures contracts on broad-based securities indices, futures contracts on narrow-based security indices and most futures contracts on most single securities are regulated as SFPs jointly by the CFTC as “contracts for the purchase and sale of a commodity for future delivery” (i.e., futures contracts) and the Securities and Exchange Commission (SEC) as securities transactions. Foreign SFPs (FSFPs) may only be offered and sold in the United States pursuant to a complex set of SEC and CFTC regulations, orders, and advisories, as described below.
The Legalization of FSFPs
The Commodity Futures Modernization Act of 2000 (CFMA) legalized the offer and sale of FSFPs in the United States. The CFMA defined SFPs, including FSFPs, as “securities” under the federal securities laws2 and as futures contracts under the CEA, thus providing the SEC and the CFTC with joint jurisdiction over SFPs. The CFMA also prohibited U.S. persons from trading FSFPs pending further regulatory action by the CFTC and SEC. That action did not occur until almost a decade after the CFMA was enacted, as described below.
The Distinction Between Broad-Based and Narrow-Based Indices
The CEA and the Exchange Act distinguish between narrow-based security indices and indices that are not narrow-based security indexes (i.e., broad-based security indices). In general, an index composed of equity securities3 is “narrow-based” if it meets any of the following criteria:
- it has nine or fewer components;
- any one of its components comprises more than 30% of the index’s weighting;
- any group of five of its components, combined, make up more than 60% of the index’s weighting; or
- the lowest weighted components comprising, in the aggregate, 25% of the index’s weighting have an aggregate dollar value of average daily trading volume of less than $50 million (or in the case of an index with 15 or more components, $30 million).
Notwithstanding the above general rule, an index composed of equity securities will be deemed to be broad-based if4
- It has at least nine components.
- No component makes up more than 30% of the index’s weighting.
- All of the component securities are registered under Section 12 of the Exchange Act.
- Each component is one of the 750 securities with the largest market capitalization and 675 securities with the largest dollar value of average daily trading volume.
The SEC Order
Section 6(h)(1) of the Exchange Act makes it unlawful for any person to effect transactions in FSFPs that are not listed on a national securities exchange or a national securities association registered pursuant to Section 15A(a) of the Exchange Act. In 2009, the SEC issued an order (the SEC Order) exempting certain sophisticated U.S. persons from Section 6(h)(1).5
The SEC Order permits the following categories of persons to “effect” (i.e., to trade) transactions in FSFPs that are traded on or subject to the rules of a non-U.S. exchange, subject to the conditions set forth in the SEC Order: (i) “qualified institutional buyers” (QIBs) as defined in Rule 144A under the Securities Act;6 (ii) non-U.S. persons as defined in Rule 902 of Regulation S under the Securities Act; (iii) registered broker-dealers (BDs) that effect transactions on behalf of QIBs or non-U.S. persons; and (iv) banks, as defined in Section 3(a)(6) of the Exchange Act, acting pursuant to an exemption from the definition of broker or dealer to effect transactions on behalf of QIBs or non-U.S. persons. The exemption permits these eligible persons to trade FSFPs that are not listed on a national securities exchange or a national securities association registered pursuant to Section 15A(a) of the Exchange Act, under the conditions described below.
Securities Underlying FSFPs as Qualifying Securities
If the FSFP is on a single equity security, the underlying security must be issued by a foreign private issuer and have its primary trading market outside the United States. If the FSFP is on a narrow-based security index composed of equity securities, at least 90% of the underlying securities in the index, at the time of the transaction, both in terms of the underlying securities and their weighting in the index, must be issued by foreign private issuers where the primary trading market of each underlying security is outside the United States.7
A “foreign private issuer” is defined, in relevant part, as any foreign issuer other than a foreign government, except for an issuer meeting the following conditions as of the last business day of its most recently completed second fiscal quarter: (1) More than 50% of the issuer’s outstanding voting securities are directly or indirectly held of record by residents of the United States, and (2) any of the following: (i) The majority of the executive officers or directors are United States citizens or residents; (ii) more than 50% of the assets of the issuer are located in the United States; or (iii) the business of the issuer is administered principally in the United States.
Listing on a Foreign Exchange
The FSFP transaction must be effected on, or be subject to the rules of, an exchange or contract market that is not required to register with the SEC under Section 5 of the Exchange Act. Because the SEC takes the view that a foreign exchange permitting U.S. persons to have direct electronic access would be required to register with the SEC, U.S. persons trading pursuant to the SEC Order are not allowed to have direct electronic access to the exchange that lists the FSFP. The SEC’s position on direct electronic access to foreign exchanges is in contrast to the CFTC’s policy, which permits such direct electronic access by U.S. persons to foreign futures exchanges subject to the foreign exchange obtaining approval from the CFTC as a “foreign board of trade.” Given that both SEC and CFTC requirements must be satisfied when trading FSFPs, U.S. persons may not trade FSFPs via direct electronic access, unless the exchange is both a foreign board of trade and registered with the SEC as a national securities exchange. In general, this means a U.S. person may not have direct electronic access to trading in FSFPs but instead must trade through an intermediary with such access.
Clearance and Settlement Outside the United States
The FSFP must not result in physical delivery in the United States of the securities underlying the contract and must be cleared and settled outside the United States. Also, a position in the FSFP must not be able to be closed or liquidated by effecting an offsetting transaction on or through the facility of any exchange or association that is registered in the United States.
Exemptions From Section 5 of the Securities Act
FSFPs are considered securities for the purposes of Section 5 of the Securities Act, and the SEC treats the clearinghouses for the exchanges on which they are traded as being the “issuers” of the FSFPs. The SEC Order does not provide exemptive relief from the registration requirements under Section 5 of the Securities Act (see discussion below).8 The SEC Order requires that absent registration, the offer and sale of FSFPs must be made in reliance on an exemption from registration, such as the exemption in Section 4(a)(2) of the Securities Act.
Brokers or Dealers
The SEC Order requires that in order to offer FSFPs in the United States, an intermediary must be either a registered BD or a CFTC-registered futures commission merchant (FCM) that has filed a notice with the SEC to qualify as a “notice broker-dealer” (a Notice BD) for the offering of FSFPs. A Notice BD is a CFTC-registered FCM that files a notice with the SEC to qualify as a Notice BD pursuant to Section 15(b)(11) of the Exchange Act and the related rules adopted by the SEC. An exempt FCM would not qualify to file to become a Notice BD with the SEC because it is not a CFTC-registered FCM. This means that only a CFTC-registered FCM can qualify to file a notice with the SEC to be a Notice BD.
The CFTC Advisory
In 2010, the CFTC’s staff issued an Advisory Concerning the Offer and Sale of Foreign Security Futures Products to Customers in the United States9 (CFTC Advisory) that clarifies the extent to which certain sophisticated persons located in the United States may transact in FSFPs under the CEA. The terms of the CFTC Advisory apply in addition to the terms of the SEC Order, as described above.
The CEA further states that eligible contract participants (ECPs) would be permitted to trade FSFPs to the same extent that they were permitted to trade foreign securities.
The CFTC Advisory refers to the SEC Order granting, among other things, an exemption from Section 6(h)(1) of the Exchange Act to permit certain sophisticated persons, for example, QIBs, to effect transactions in certain FSFPs. Under the SEC’s Rule 144A, persons who “in the aggregate own and invest on a discretionary basis at least $100 million in securities of issuers” are QIBs. By comparison, a U.S. investor is considered an ECP under Section 1a(18) of the CEA if, among other things, it acts for its own account and is a financial institution, a state-regulated insurance company, a federally regulated investment company, a commodity pool whose total assets exceed $5 million, or a business organization whose total assets exceed $10 million. Pursuant to the CFTC Advisory, if FSFPs are offered and sold to U.S. investors in compliance with the SEC Order, investors in the United States must be ECPs in addition to being QIBs.10
Offer and Sale of Security Futures Products Pursuant to a Private Offering
FSFPs are considered securities for the purposes of Section 5 of the Securities Act. The SEC Order does not provide exemptive relief from the registration requirements under Section 5, which requires all offers and sales of securities to be registered with the SEC unless there is an available exemption from registration. The SEC has long treated the clearinghouse through which security derivatives are cleared as being the “issuer” of those derivatives. Section 4(a)(2) of the Securities Act exempts from registration offers and sales by an issuer that do not involve “any public offering.” This is a transactional exemption and only exempts from registration the particular offer and sale of securities by the issuer. Section 4(a)(2) provides a mechanism for a foreign exchange to offer and sell narrow-based security index futures in the United States.
The implications associated with relying on Section 4(a)(2) are that FSFPs sold to U.S. customers pursuant to the SEC Order will be “restricted securities” subject to limitations on transferability. In addition, the SEC Order is conditioned on persons not taking delivery in the United States of the security or securities underlying the FSFP in connection with settlement. In addition, positions in FSFPs cannot be transferred to another investor in the United States but can be disposed of only in an offsetting transaction on an exchange or contract market outside the United States. This fact, together with the restriction on physical delivery in the United States, is intended to help safeguard against development of a public market in the United States with respect to unregistered securities as a result of the ability to effect transactions in FSFPs pursuant to the SEC Order.
Penalties for Failure to Comply With Applicable Law and Regulations
U.S. state and federal laws and U.S. common law provide a number of remedies for violation of the securities and commodities laws and raise a number of risks for those who violate applicable law, including the risk of litigation from private parties and the risk of the SEC and/or the CFTC’s bringing an enforcement action. It is difficult to predict with any certainty the “worst case” scenario for violations of the applicable statutes and rules, but one data point is the 2013 SEC investigative report with respect to Eurex.11
In the Eurex Report, the SEC explained that Eurex had been offering and selling futures contracts on broad-based security index futures pursuant to a CFTC no-action letter but that the indexes underlying the futures contracts had become narrow-based and therefore caused the futures contracts to become FSFPs. This caused Eurex to be in violation of Section 5 of the Exchange Act and Section 5 of the Securities Act. The SEC determined not to bring an enforcement action against Eurex but used this as an opportunity to warn market participants of the need for operational controls to monitor indices to ensure that they remain broad-based lest they become subject to SEC jurisdiction. If the SEC were to be presented with similar facts now, it is unlikely the SEC would abstain from bringing an enforcement case proceeding against the relevant exchange.
Trading Single Securities and Narrow-Based Indices OTC
The requirements described herein for the purchase and sale of foreign SFPs in the United States do not apply to over-the-counter (OTC) derivative transactions in the same underliers. OTC derivatives therefore may be a viable alternative means by which a trader may access FSFPs that otherwise would be prohibited for offer and sale in the United States.
NFA Security Futures Product Proficiency
The Exchange Act requires the National Futures Association (NFA) to “have rules that ensure that members and natural persons associated with members meet such standards of training, experience, and competence necessary to effect transactions in security futures products and [that they] are tested for their knowledge of securities and security futures products.”12 The CEA requires NFA to “establish training standards and proficiency testing for persons involved in the solicitation of transactions subject to the provisions of [the CEA], supervisors of such persons, and all persons for which it has registration responsibilities, and a program to audit and enforce compliance with such standards[.]”13
NFA has implemented these mandates through Interpretive Notice 9049, in which NFA determined to allow its members and their associated persons to meet the security futures proficiency requirements by taking an “appropriate training course” before they engage in activities involving security futures products. NFA’s SFP proficiency requirements are agnostic to whether the SFP is traded on a U.S. or a foreign exchange. The training may be comprised of any training program that covers the subject matter included in a joint content outline developed by NFA, the Financial Industry Regulatory Authority, and a number of exchanges or a web-based training program accessible through NFA’s website.
