The Commodity Futures Trading Commission (CFTC) recently adopted CFTC Regulation 1.71 to implement new section 4d(c) of the Commodity Exchange Act, which requires FCMs and IBs to implement a conflict of interest system and procedures with respect to its research function and its trading and clearing activities. Except as for the requirements under Regulation 1.71(d) related to clearing activities, FCMs and IBs were required to be in compliance with Regulation 1.71 by August 3, 2012. Although the final rulemaking set a June 4, 2012 compliance date, the Commission issued a No-Action letter on June 1, 2012 extending the final compliance date for Regulation 1.71(a)-(c), (e) and (f) to the August 3, 2012 date. A copy of the final regulation is available at http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2012-5317a.pdf.
Under CFTC Regulation 1.71, FCMs and IBs are required to adopt written policies and procedures that are reasonably designed to ensure that the firm and its employees are in compliance with Regulation 1.71. Subsection 1.71(a) sets forth a number of definitions that are material to understanding the requirements of the Regulation. Subsections 1.71(b) and (c) set forth most of the substantive requirements as follows:
- Restrictions on relationship with the research department including:
- Non-research personnel may not direct a research analyst's decision to publish a research report or direct the views and opinions in the report;
- Research analysts may not be under the supervision, control (including with respect to performance evaluation and compensation) of employees of the firm's business trading unit or clearing unit; and
- Non-research personnel may not review or approve a research report prior to publication except for certain specified reasons, which must be done through authorized legal and compliance personnel.
- Restrictions on communications that provide that a research analyst's written or oral communication to customers relating to a derivative may not omit any material fact or qualification that would make the communication misleading to a reasonable person.
- Restrictions on research analyst compensation that prohibit FCMs and IBs from considering a research analyst's contribution to the firm's trading or clearing business in determining compensation.
- FCMs and IBs are prohibited from offering favorable or threatening to change research to a customer as consideration or inducement for business or compensation.
- FCMs, IBs and their research analysts must comply with specific disclosure requirements relating to a research analyst's financial interest in any derivative that the research analyst follows.
- FCMs, IBs and their employees who are involved in the firm's trading or clearing activities are prohibited from retaliating against a research analyst employed by the firm or its affiliate as a result of a research report (made in good faith by the analyst) that may adversely affect the FCM's or IB's trading or clearing activities.
If an FCM or IB will not utilize research reports, they must still develop policies and procedures. However, these procedures may indicate that the FCM or IB will not utilize research reports but, in the event that they change this policy, procedures relating to the above will be developed.
The Regulation provides an exemption from the above requirements for smaller IBs that, over the preceding 3 years, have generated $5 million or less in aggregate gross revenues from its IB activities. IBs qualifying for this exemption, however, must establish structural and institutional safeguards reasonably designed to ensure that the activities of persons who research or analyze the price or market for any commodity or derivative are separated by appropriate informational partitions from the review, pressure or oversight of persons involved in trading or clearing activities.
As defined in the regulation, the term research report means any written communication (including electronic) that includes an analysis of the price or market for any derivative, and that provides information reasonably sufficient upon which to base a decision to enter into a derivatives transaction. This term does not include:
- Communications distributed to fewer than 15 persons;
- Commentaries on economic, political or market conditions;
- Statistical summaries of multiple companies' financial data, including listings of current ratings;
- Periodic reports or other communications prepared for investment company shareholders or commodity pool participants that discuss individual derivatives positions in the context of a fund's past performance or the basis for previously-made discretionary decisions;
- Any communications generated by an employee of the business trading unit that is conveyed as a solicitation for entering into a derivatives transaction, and is conspicuously identified as such; and
- Internal communications that are not given to current or prospective customers.
With respect to communications that are used to solicit a customer or prospective customer to enter into a derivatives transaction, firms should ensure that these are clearly labeled solicitations and, as noted above, these will fall outside the definition of a research report.
The regulation also discusses the use of independent third party research reports, in which the person or entity producing the report has no affiliation or business or contractual relationship with the distributing FCM or IB or their affiliates that is reasonably likely to inform the content of its research reports and makes content determinations without any input from the distributing FCM or IB or their affiliates.
If an FCM or IB distributes or makes available any independent third-party research report, they must accompany the research report with, or provide a web address that directs the recipient to, the current applicable disclosures as they pertain to the FCM or IB. Each FCM or IB must establish written policies and procedures reasonably designed to ensure the completeness and accuracy of all applicable disclosures.
Enhancements to the Protection of Customer Segregated Funds
NFA recently submitted a rule proposal to the CFTC that will require each FCM to provide its Designated Self-Regulatory Organization (DSRO) with view-only access via the Internet to account information for each of the FCM's customer segregated funds account(s) maintained and held at a bank or trust company. The same requirement would apply to the FCM's customer secured account(s) held for customers trading on foreign futures exchanges.
In addition, the rule states that if a bank or trust company is unable to allow the FCM to provide its DSRO with view-only full access via the Internet, the bank or trust company will not be deemed an acceptable depository to hold customer segregated and secured accounts.
NFA intends to expand this approach, once it is implemented, to receive daily reports from all depositories for customer segregated and secured accounts, including clearing FCMs. NFA plans to develop a program to compare these balances with those reported by the firms in their daily segregation reports. The system will then generate an immediate alert for any material discrepancies.
