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SECURITIES AND EXCHANGE COMMISSION
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Self-Regulatory Organization; Notice of Filing and Immediate Effectiveness of Proposed Rule Change by National Futures Association Relating to Security Futures Products
Pursuant to Section 19(b)(7) of the Securities Exchange Act of 1934 ("Exchange Act")1 , and Rule 19b-7 under the Exchange Act2 , notice is hereby given that on ______________, National Futures Association ("NFA") filed with the Securities and Exchange Commission ("SEC" or "Commission") the proposed rule change described in Items I, II, and III below, which Items have been prepared by NFA. The Commission is publishing this notice to solicit comments on the proposed rule change from interested persons. NFA also has filed the proposed rule change with the Commodity Futures Trading Commission ("CFTC").
NFA, on July 20, 2001, submitted the proposed rule change to the CFTC for approval. The CFTC approved the proposed rule change on August 20, 2001.
I. Self-Regulatory Organization's Description of the Proposed Rule Change
The Commodity Futures Modernization Act of 2000 ("CFMA") amended Section 15A of the Exchange Act to add a new subsection (k)3 , which makes NFA a national securities association for the limited purpose of regulating the activities of Members who are registered as brokers or dealers in security futures products under Section 15(b)(11) of the Exchange Act4. The most significant provisions of the proposed rule change make the requirements that apply to the security futures activities of these Members reasonably comparable to those that apply to NASDR members, as required by Section 15(k)(2) of the Exchange Act5.
II. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change
NFA has prepared statements concerning the purpose of, and basis for, the proposed rule change, burdens on competition, and comments received from members, participants, and others. The text of these statements may be examined at the places specified in Item IV below. These statements are set forth in Sections A, B, and C below.
The CFMA lifted the 18-year ban on single stock futures and narrow-based security indices (security futures products) and regulates these products as both securities and futures. The CFMA amended Section 15A of the Exchange Act to add a new subsection (k)6 , which makes NFA a national securities association for the limited purpose of regulating the activities of Members who are registered as brokers or dealers in security futures products under Section 15(b)(11) of the Exchange Act7 , which was also added by the CFMA. Section 15A(k)(2)8 requires NFA to have anti-fraud, anti-manipulation, and customer protection rules reasonably comparable to those of NASD Regulation, Inc. ("NASDR") for the purpose of governing the security futures activities of these Section 15(b)(11)9 broker-dealers.
NFA already has anti-fraud, anti-manipulation, and customer protection rules that have proven effective in governing the futures activities of its Members. However, NFA's rules sometimes take a different approach than NASDR's rules and, as a result, they do not correspond in every instance. Therefore, NFA has adopted the proposed rule change in order to ensure that NFA meets the standards imposed by Section 15A(k)(2) of the Exchange Act10.
In NFA staff's discussions with SEC staff, SEC staff told us that NFA's rules should be comparable to those NASDR rules that apply to options since both are derivative instruments. SEC staff also told NFA to include those rules that apply to writing options since the risks of futures transactions are more similar to the risks of writing options than to the risks of purchasing them. These principles guided NFA in developing the proposed rule change. A more detailed discussion of the rule change follows.
Bylaw 1101 (Doing Business With Non-Members)
Bylaw 1507, Compliance Rule 1-1, and Code of Arbitration Section 1 (Definitions)
Compliance Rule 1-1 has also been amended to add a definition of "Exchange Act," since the Exchange Act is now referred to in a number of places in the Compliance Rules.
Compliance Rule 2-7 (Designated Security Futures Principals)
Corresponding changes to Compliance Rules 2-8, 2-29, and 2-30 require a designated security futures principal to review discretionary trades, approve promotional material, and approve customer accounts for security futures transactions.
Compliance Rules 2-22 and 2-26
CFTC Regulations 155.315 and 155.416 dictate the terms under which an associated person ("AP") of one Member can open and trade an account with another Member. Compliance Rule 2-26 has been amended to incorporate these regulations in order to make it comparable to NASDR Conduct Rule 3050.
Compliance Rule 2-29 (Promotional Material)
The amendment to Compliance Rule 2-29(b) adds new sub-section (6) regarding testimonials. This requirement is actually stricter than NASDR Conduct Rule 2210(d)(2)(D), which is the comparable NASDR requirement, since the proposed NFA requirement actually prohibits the use of any testimonial that is not representative of all reasonably comparable accounts.
A new section (j) has been added to be comparable with various requirements in NASDR Conduct Rules 2210 and 2220. This section applies only to promotional material of passported Members (and their Associates) that specifically refers to security futures products. Among other things, Compliance Rule 2-29(j):
Compliance Rule 2-30 (Suitability)
NFA Compliance Rule 2-30 requires Members (and their Associates) to obtain information about each customer's experience, income, net worth and age before opening a futures account. It also requires Members to give risk disclosure, with the risk disclosures required by the CFTC as the minimum. Compliance Rule 2-30 requires Members to provide additional risk disclosure if the customer needs it to make an informed judgment about whether he or she should be involved in the futures markets. In fact, if the Member believes that futures are simply too risky for that customer, the Member must tell the customer that he has no business trading futures. This is true even if the Member makes no recommendations whatsoever to the customer. If the customer still decides to trade futures, however, the Member may open the account.
Like NASDR requirements, Compliance Rule 2-30 is designed to keep customers from trading futures if they are unsuitable. Unlike NFA Compliance Rule 2-30, however, NASDR Conduct Rules 2310, 2860(16), 2860(19), and IM-2860-2: (1) require members to obtain more extensive information from natural person customers, (2) require members to specifically approve or disapprove security options accounts based on an evaluation of the customer's suitability to trade those products, and (3) explicitly prohibit members from making unsuitable recommendations. Therefore, NFA has added a new section (j) to Compliance Rule 2-30 to include these requirements for security futures and apply them to NFA Members who are not also members of NASDR (and therefore are not subject to NASDR's suitability requirements).
NFA and a number of other self-regulatory organizations are currently drafting a standardized disclosure statement that must be given to all security futures customers. Compliance Rule 2-30(b) has been revised to require Members to provide this statement when or before an account is approved to trade security futures products.
Compliance Rule 2-37 (Security Futures Products)
Interpretive Notice Regarding Enhanced Supervisory Requirements
Interpretive Notice Regarding Obligations to Customers and Other Market Participants
One of the lynchpins of the futures industry is the concept that registrants may not trade ahead of customer orders. Most, if not all, of the futures exchanges have rules prohibiting their members from engaging in this conduct, and CFTC Regulations 155.3(a)21 and 155.4(a)22 require FCMs and IBs to have and enforce procedures to insure that they and their employees do not trade ahead of customer orders. Although NFA does not have a specific requirement prohibiting Members and Associates from trading ahead of customer orders, NFA has always considered it a violation of Compliance Rule 2-4. However, in order to make NFA rules more comparable to NASDR IM-2110-2, NFA has specifically prohibited that conduct in this new interpretive notice. As noted previously, CFTC Regulations 155.323 and 155.424 have also been incorporated by reference into NFA Compliance Rule 2-26.
This interpretive notice also contains several provisions that apply only to passported Members and their Associates when they engage in security futures activities. These provisions: (1) prohibit trading ahead of research reports (comparable to NASDR IM-2110-4); (2) prohibit trading based on knowledge of an imminent block transaction (generally comparable to NASDR IM-2110-3), with an exception for hedging counterparty risk under approved exchange block rules; and (3) require a sound basis for evaluating the facts regarding a particular security futures product (comparable to NASDR Conduct Rule 2210(d)(1)(A)).
Interpretive Notice Regarding Special Supervisory Requirements for Members Registered as Broker-Dealers Under Section 15(b)(11) of the Securities Act of 1934
Among other things, this interpretive notice requires that:
Interpretive Notice on Use of Past or Projected Performance and Disclosing Conflicts of Interest for Security Futures Products
The rule change will not impose any burden on competition that is not necessary or appropriate in furtherance of the purposes of the Exchange Act and the CEA, as they were amended by the CFMA. In fact, the CFMA is designed to promote an even regulatory playing field among securities and futures registrants - and among Members of NFA and members of NASDR - so that neither group has a competitive advantage over the other. NFA's rule change achieves that objective.
NFA worked with Member committees and industry trade associations in developing the rule change. NFA did not, however, publish the rule change to the membership for comment. NFA received one written comment letter from an industry trade association, which generally supported the rule change. III. Date of Effectiveness of the Proposed Rule Change and Timing for Commission Action
The proposed rule change has become effective on August 20, 2001. Within 60 days of the date of effectiveness of the proposed rule change, the Commission, after consultation with the CFTC, may summarily abrogate the proposed rule change and require that the proposed rule change be refiled in accordance with the provisions of Section 19(b)(1) of the Exchange Act27.
IV. Solicitation of Comments
Interested persons are invited to submit written data, views and arguments concerning the foregoing, including whether the proposed rule change conflicts with the Exchange Act. Persons making written submissions should file nine copies of the submission with the Secretary, Securities and Exchange Commission, 450 Fifth Street, NW, Washington, DC 20549-0609. Comments also may be submitted electronically to the following e-mail address: firstname.lastname@example.org. Copies of the submission, all subsequent amendments, all written statements with respect to the proposed rule change that are filed with the Commission, and all written communications relating to the proposed rule change between the Commission and any person, other than those that may be withheld from the public in accordance with the provisions of 5 U.S.C. 552, will be available for inspection and copying in the Commission's Public Reference Room. Copies of these filings also will be available for inspection and copying at the principal office of NFA. Electronically submitted comments will be posted on the Commission's Internet website (http://www.sec.gov). All submissions should refer to File No. SR-NFA-2001-01 and should be submitted by _____.
For the Commission, by the Division of Market Regulation, pursuant to delegated authority28.
Jonathan G. Katz
1 15 U.S.C. 78s(b)(7).