SEC Permits Limited Trading of Foreign Security Futures

Lawrence B. Patent, Of Counsel, K&L Gates LLP.


Congress first authorized trading on U.S. exchanges of security futures, which include futures on individual securities as well as on narrow-based security indices,[1] by passage of the Commodity Futures Modernization Act of 2000 ("CFMA").[2] The CFMA made security futures subject to the joint jurisdiction of the Commodity Futures Trading Commission ("CFTC") and the Securities and Exchange Commission ("SEC"), and the agencies adopted a series of regulations in 2001 and 2002 to govern trading of security futures on U.S. markets.

Security futures had been trading around the world long before 2000, and with respect to trading of security futures by U.S. persons on non-U.S. markets, the CFMA amended both the Commodity Exchange Act ("CEA") and the Securities Exchange Act of 1934 ("Exchange Act") to authorize the CFTC and SEC to jointly issue regulations or orders to permit the offer and sale of a security futures product traded on a foreign board of trade to U.S. persons.[3] Nevertheless, the two agencies, despite some work in this area by their respective staffs, did not implement these provisions of the relevant statutes. Congress took note of this last year, and when it reauthorized the CFTC as part of the 2008 Farm Bill,[4]it directed that "[t]he SEC, the CFTC, or both, as appropriate, shall take action under their existing authorities to permit, by June 30, 2009, the trading of futures on certain security indexes by resolving issues related to foreign security indexes."

SEC Order

The SEC has now taken action in response to the latest Congressional directive. On June 30, 2009, the SEC issued an Order[5] granting exemptions from various provisions of the Exchange Act to permit a limited degree of trading in non-U.S. security futures by certain U.S. persons. The SEC Order applies only to qualified institutional buyers ("QIBs")[6] and non-U.S. persons,[7] and to registered securities brokers or dealers[8] or banks[9] that effect transactions on behalf of QIBs and non-U.S. persons.[10] The products permitted to be traded in accordance with the SEC Order include futures contracts on individual equity or debt securities, as well as narrow-based security indices. If the underlying instrument is an individual equity security, it must be:

a security issued by a foreign private issuer (as defined in Rule 3b-4(c) of the [Exchange Act] and Rule 405 under the [Securities Act] for which at least 55 percent of the worldwide trading volume in the security took place in, on, or through the facilities of a securities market or markets in a single foreign jurisdiction or in no more than two foreign jurisdictions during the issuer's most recently completed fiscal year. If the trading in the foreign private issuer's security is in two foreign jurisdictions, the trading for the issuer's securities in at least one of the two foreign jurisdictions must be greater than the trading in the U.S. for the same class of the issuer's securities in order for such security's primary trading market to be considered outside the U.S.

If a debt security is the underlying product, the security must be a note, bond, debenture or evidence of indebtedness issued or guaranteed by a foreign government as defined in Rule 405 under the Securities Act[11]that is eligible to be registered with the SEC under Schedule B of the Securities Act.

If a foreign security future is based upon a security index, the exemption is conditioned on at least 90 percent of the securities in the index, at the time of the transaction,[12]both in terms of the number of underlying securities and their weighting in the index, being (i) equity securities issued by foreign private issuers, or (ii) debt securities issued or guaranteed by a foreign government, in both cases as described above. The SEC Order, therefore, permits up to 10 percent of the number and weighting of securities in the index to be securities of issuers that do not meet the above conditions - i.e., the issuers either are not foreign private issuers or are foreign private issuers but the securities' primary trading market is in the U.S. - if these securities are issued by companies that are required to file reports pursuant to Section 13 or 15(d) of the Exchange Act.

The SEC Order further provides that the security futures transaction must (i) be effected on, or 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, (ii) not result in physical delivery in the U.S. of the securities underlying the contract, and (iii) be cleared and settled outside the U.S. The SEC Order also notes that the offer and sale of security futures must be exempt from registration under the Securities Act, and that the statutory exemption from registration in Section 3(a)(14) of the Securities Act[13]is not available for offers and sales of security futures that are not cleared by a registered clearing agency or listed on a registered national securities exchange. Accordingly, the offer and sale of the security future must be made in reliance on another exemption from registration, such as the exemption in Section 4(2) of the Securities Act for offerings not involving public offerings or the safe harbor provisions of Regulation D or Regulation S, provided the conditions of those safe harbors, including the restrictions on general solicitation and general advertising, are satisfied.

No Need for CFTC Action

The Congressional directive referred to in the 2008 Farm Bill was aimed at both the SEC and CFTC. As of yet, the CFTC has not taken action in response. However, it should not be necessary for the CFTC to do so to make the SEC Order effective. In the CFMA, Congress added a new Section 2(a)(1)(F)(ii) to the CEA, which provides that nothing in the CEA is intended to prohibit any eligible contract participant ("ECP") in the U.S. from purchasing or carrying securities futures products traded on a foreign board of trade, so long as the underlying securities for such security futures products are traded principally on, by, or through any exchange or market located outside the U.S. Because any QIB would likely qualify as an ECP under the CEA,[14]persons who can satisfy the conditions of the SEC Order should be able to invest in foreign security futures without violating the CEA.

In light of the fact that it took the SEC more than eight and one-half years since the passage of the CFMA to permit any trading in foreign security futures by U.S. persons, it is unlikely to expect the SEC to revisit this issue any time soon. The fact that the SEC acted unilaterally in response to the Congressional directive in last year's Farm Bill also does not auger well for a change in the SEC's position, despite the call by the Administration in its recently issued White Paper on Financial Regulatory Reform for the CFTC and SEC to harmonize their regulatory frameworks.

Alternative for Other Investors

This still leaves numerous persons who otherwise would be able to enter into foreign security futures transactions in accordance with Section 2(a)(1)(F)(ii) of the CEA unable to do so. That group includes persons who satisfy the ECP definition but are not QIBs, a category that includes numerous registered investment companies, commodity pools, pension plans, corporations and high net worth individuals. These persons may have real needs for risk management based upon exposures in foreign financial markets or to the economic conditions in other countries, or may want to gain some exposure to those markets as part of the asset allocation in their investment portfolio. It is somewhat anomalous that ECPs may enter into various types of off-exchange derivative transactions,[15]yet are not permitted to engage in security futures transactions on foreign boards of trade that are subject to an exchange trading environment, a clearance and settlement process, and a regulatory framework in the home country of the exchange, and also are subject to antifraud provisions of U.S. law.

There is another provision of the CEA regarding foreign security futures that was not included in the Exchange Act. Section 2(a)(1)(F)(i) of the CEA provides that "Nothing in [the CEA] is intended to prohibit [an FCM] from carrying security futures products traded on or subject to the rules of a foreign board of trade in the accounts of persons located outside of the [U.S.]." Despite the fact that there is no similar provision in the Exchange Act, the SEC staff long ago issued a no-action letter that provided relief so that securities broker-dealers could carry foreign security futures positions of persons located outside the U.S.[16] However, the recent SEC Order did not provide relief with respect to trading in foreign security futures for all ECPs, as the CEA would permit, but rather took the more limited route of permitting such trading only by non-U.S. persons or QIBs. Accordingly, at the present time, a U.S. person that wants to trade in foreign security futures must comply with the provisions of the SEC Order and rely upon Section 2(a)(1)(F)(ii) to the CEA to undertake such activity. An ECP that is not a QIB and has a need to hedge the risk of foreign security holdings or international economic conditions, or wants exposure to foreign financial markets, must find another ECP that is willing to enter into an off-exchange derivative transaction that would mirror the return of foreign security futures. It should be noted that the Administration White Paper also calls for moving off-exchange derivative trading to exchange platforms to the extent possible, so even this strategy may need to be reconsidered if statutory and regulatory changes affecting derivatives are adopted.

Lawrence B. Patent, Of Counsel,

Larry Patent is of counsel in the firm's Washington, D.C. office. His principal areas of concentration are investment management, commodity futures, financial services and derivatives matters.

Mr. Patent's experience includes substantial involvement with all of the Commodity Futures Trading Commission (CFTC) regulations related to intermediaries, including registration and fitness, sales practices, disclosure, reporting, recordkeeping, minimum financial requirements, customer funds protection, international trading, foreign currency, anti-money laundering, bankruptcy, risk assessment and managed funds.

Prior to joining K&L Gates, Mr. Patent served as deputy director of the Division of Clearing and Intermediary Oversight at the CFTC. Mr. Patent worked at the CFTC in various capacities for more than 30 years.

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[1]A narrow-based security index is an index with fewer than nine component securities or in which a component security comprises more than 30 percent of the index's weighting. Other indexes may be included in this definition based upon the nature of the component securities and the weighting of the five highest weighted securities or the lowest weighted component securities, comprising 25 percent of the index's weighting having an aggregate dollar value of average daily trading volume of less than $50 million ($30 million if the index has 15 or more component securities). Section 1a(25) of the Commodity Exchange Act and Section 3(a)(55)(B) of the Securities Exchange Act of 1934.

[2]Pub. L. No. 106-554, 114 Stat. 2763 (2000).

[3]Section 206(l) of the CFMA, adding Section 6(k) of the Exchange Act, and Section 251(i) of the CFMA, adding Section 2(a)(1)(E) of the CEA.

[4]Food, Conservation and Energy Act of 2008, Pub. L. No. 110-246, Sec. 13106, 122 Stat. 1651, 2197 (2008), reprinted inNotes to 7 U.S.C.A. õ2.

[5]74 Fed. Reg. 32200 (July 7, 2009).

[6] A QIB is defined in Rule 144A under the Securities Act of 1933 ("Securities Act"), 17 C.F.R. õ230.144A, and generally requires that the institution, acting for its own account or the accounts of other QIBs, in the aggregate owns and invests on a discretionary basis at least $100 million in securities of issuers that are not affiliated with the entity.

[7]A non-U.S. person is defined in Rule 902(k) of Regulation S under the Securities Act, 17 C.F.R. õ230.902(k).

[8]The exemption also applies to "Notice Broker-Dealers," which are futures commission merchants ("FCMs") or introducing brokers that register with the SEC as a broker or dealer pursuant to Section 15(b)(11) of the Exchange Act, and whose only securities-related activity involves security futures. A foreign broker or dealer could effect transactions pursuant to the SEC Order if it is exempt from U.S. broker-dealer registration under Rule 15a-6 under the Exchange Act or alternative exemptions from the registration requirements under Exchange Act Section 15(a)(1) that the SEC also issued on June 30, 2009.

[9]For these purposes, the term "bank" is defined in Section 3(a)(6) of the Exchange Act, and a bank must be acting pursuant to an exception or exemption from the definition of "broker" or "dealer" in Sections 3(a)(4)(B), 3(a)(4)(E), or 3(a)(5)(C) of the Exchange Act or the rules thereunder.

[10]A broker, dealer or bank must reasonably believe that the person for whom it is effecting transactions is a QIB or a non-U.S. person. In addition, the broker, dealer or bank acting for its own account would not be able to rely on the exemption in the SEC Order, unless such broker, dealer, or bank is a QIB in its own right.

[11]17 C.F.R. õ230.405. Rule 405 defines "foreign government" as the government of a foreign country or political subdivision of a foreign country.

[12]A security or narrow-based security index underlying a security future may satisfy the conditions in the SEC Order at the time a transaction is effected, but may cease to satisfy such conditions while a security future position remains open. The SEC Order permits persons who entered into positions in foreign security futures in compliance with the exemption to close such positions.

[13]Section 3(a)(14) of the Securities Act provides an exemption for: "Any security futures product that is - (A) cleared by a clearing agency registered under . . . [the Exchange Act] or exempt from registration [thereunder]; and (B) traded on a national securities exchange or a national association registered pursuant to . . . [the Exchange Act]."

[14]An ECP is defined in Section 1a(12) of the CEA. That definition includes individuals and entities with total assets exceeding $10 million, commodity pools and pension plans with total assets exceeding $5 million, and various other institutions and registered entities based simply upon their status as such. Because the QIB definition generally requires ownership of at least $100 million in securities, any QIB should also qualify as an ECP.

[15]SeeSections 2(d), 2(g) and 2(h)(1) of the CEA.

[16]Letter from Annette Nazareth, Director, Division of Market Regulation, to Securities Industry Association and Futures Industry Association, August 20, 2002, which may be accessed at the following URL: It is reprinted in [2002 Transfer Binder] Fed. Sec. L. Rep. (CCH) ô78,327.

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