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September 26, 2007
PRESIDENT AND CHIEF EXECUTIVE OFFICER
NATIONAL FUTURES ASSOCIATION
BEFORE THE SUBCOMMITTEE ON GENERAL FARM COMMODITIES
AND RISK MANAGEMENT
COMMITTEE ON AGRICULTURE
SEPTEMBER 26, 2007
I testified before this Subcommittee in 2003 and in 2005 about off-exchange forex futures that were being sold to retail customers. I stated then and believe now that certain provisions of the Commodity Futures Modernization Act of 2000 and subsequent case law had the unintended consequence of making unsophisticated, retail customers the prey of fly-by-night operators. Let me put these issues in some overall context, describe in detail the problems we have seen in the statute and share with you some proposed solutions.
In the CFMA Congress attempted to resolve the so-called Treasury Amendment issue once and for all by clarifying that the CFTC does, in fact, have jurisdiction to protect retail customers investing in foreign currency futures. The basic thrust of the CFMA in this area was that foreign currency futures with retail customers were covered by the Commodity Exchange Act ("Act") unless the counterparty was an "otherwise regulated entity," such as a bank, a broker-dealer or an FCM. When I testified here in 2003, I told you that NFA Member FCMs held $170 million in retail customer funds trading off-exchange forex. Four years later, that number is now over $1 billion. With this dramatic growth there have been some pretty dramatic problems.
Members acting as counterparties to retail forex transactions account for less that 1% of NFA's membership. Unfortunately, they also account for over 20% of the customer complaints filed with our arbitration program, over 50% of NFA's current enforcement docket and over 50% of the emergency enforcement actions NFA has taken over the last year.
There a number of problems in the current statute that have contributed to these problems. If you look at the firms that have caused virtually all of the customer protection problems in retail forex, they share a couple of traits. First of all, they are not really FCMs at all. Congress intended to allow FCMs, along with banks, broker-dealers and insurance companies, to act as counterparties to retail forex transactions because they are all "otherwise regulated entities." The wording of the statute, though, opened the door for firms that are not really FCMs to take advantage of the FCM exemption. Firms became registered as FCMs that are FCMs in name only-they do no exchange-traded futures. They are registered as FCMs solely to qualify to do retail forex business. To make matters worse, due to a further anomaly in the statute, the Act currently does not provide the CFTC with any rulemaking authority over these firms at all. Clearly, Congress did not intend to allow firms that are FCMs in name only to act as counterparties to retail forex futures. Congress should fix this problem by limiting the FCMs that can act as counterparties to those that are primarily and substantially engaged in the activities described in Section 1(a)(20) of the Act.
The second trait that marks the problem firms in retail forex is that most, though not all, have been thinly capitalized. Congress long ago recognized that acting as a dealer involves greater risk than acting as an agent in futures trading, the way a traditional FCM does. That is why Congress in 1978 imposed a $5 million net worth requirement for firms granting dealer options and why the CFTC created a $2.5 million capital requirement for leverage transaction merchants in 1984. Congress should amend Section 2(c) of the Act to require FCMs acting as counterparties to retail forex transactions to maintain minimum capital of at least $20 million. NFA has raised the capital requirements for forex dealers several times but this congressional action could ensure that firms can meet their obligations to their customers and have a significant financial stake in their business.
NFA is strongly supportive of both of these solutions to the customer protection problems we have experienced with retail forex. We are also strongly supportive of giving the CFTC rulemaking authority over FCM only firms (i.e. those that are not otherwise enumerated in Section 2(c) of the Act to act as retail forex counterparties). It is simply paradoxical to call these FCMs "otherwise regulated" when, other than anti-fraud jurisdiction, there is no federal regulatory oversight of these firms' activities.
There's one more forex problem I should mention that poses significant customer protection issues based upon the wording of the CFMA. Specifically, the wording of the statute currently only requires the counterparty to these transactions to be an otherwise regulated entity. This creates the possibility that an FCM, for example, might be the counterparty but the firm that actually does the telemarketing for these products is completely unregistered and unregulated. There are literally hundreds of these unregulated firms selling off-exchange forex transactions to retail customers and in some instances the people making the sales pitches have been barred from the futures industry for sales practice fraud. I do not think that's what Congress intended at all, and H.R. 4473 passed by the House in 2005 contained an amendment to Section 2(c) of the Act to make clear that not only the counterparties but also the persons actually selling these products to retail customers must be registered with the CFTC and subject to its jurisdiction. We, of course, support this amendment.
In the last few years we have also seen a growing number of firms acting as trading advisors and pool operators that trade exclusively off-exchange forex. Under the current statute, these firms are not required to be registered and their customers do not receive the same regulatory protections as customers of CPOs and CTAs that trade on-exchange. Some of these unregistered firms tout outlandish performance claims that cannot be substantiated. We believe that H.R. 4473's amendment should be extended to require those persons that manage accounts or pooled investment vehicles on behalf of retail customers to register and be subject to the CFTC's jurisdiction.
The last issue I wanted to discuss brings us back to the Zelener case. As you may recall, in the Zelener case the CFTC attempted to close down a boiler room selling off-exchange forex trades to retail customers. The District Court found that retail customers had, in fact, been defrauded but that the CFTC had no jurisdiction because the contracts at issue were not futures. The Seventh Circuit affirmed that decision. The "rolling spot" contracts in Zelener were marketed to retail customers for purposes of speculation; they were sold on margin; they were routinely rolled over and over and held for long periods of time; and they were regularly offset so that delivery rarely, if ever, occurred. In Zelener, though, the Seventh Circuit based its decision that these were not futures contracts exclusively on the terms of the written contract itself. Because the written contract in Zelener did not include a guaranteed right of offset, the Seventh Circuit ruled that the contracts at issue were not futures.
For a short period of time, Zelener was just a single case addressing this issue. However, time has proven that the CFTC cannot litigate itself out of the Zelener problem. Since 2004, various Courts have continued to follow the Seventh Circuit's approach in Zelener causing the CFTC to lose enforcement cases relating to forex fraud. Therefore, Zelener allows completely unregulated firms and individuals through clever draftsmanship to sell to retail customers contracts that look like futures and act like futures outside the CFTC's jurisdiction. The bottom line is that these Court decisions make it much harder for the Commission to prove that contracts sold to retail customers to speculate in commodity prices are futures, makes it easier for the unscrupulous to avoid CFTC regulation and creates a real, live customer protection issue. Unsophisticated retail customers are being victimized by high-pressured sales pitches for foreign currency futures look-alike products. These retail customers are the ones who most need regulatory protection, and that protection should not be stripped from them because a clever lawyer finds a loophole in the law.
NFA recognizes that H.R. 4473 addressed the Zelener problem with regard to retail forex. NFA applauds those efforts in addressing the current scam of choice-forex-among fraudsters and believes that any future reauthorization legislation should at the very least incorporate H.R. 4473's approach to this issue. However, NFA remains concerned that the rationale of the Zelener decision and its progeny is not limited to foreign currency products. Similar contracts for unleaded gas, heating oil, agricultural products or virtually any other commodity could be sold to the public in an unregulated environment.
NFA and the exchanges have developed a fix to Zelener that goes beyond forex and does not have unintended consequences. Our approach codifies the approach the Ninth Circuit took in CFTC v. Co Petro-which was the accepted and workable state of the law until Zelener-without changing the jurisdictional exemptions in Section 2(c) of the Act. In particular, our approach would create a statutory presumption that leveraged or margined transactions offered to retail customers are futures contracts if the retail customer does not have a commercial use for the commodity or the ability to make or take delivery. This presumption is flexible and could be overcome by showing that the transactions were not primarily marketed to retail customers or were not marketed to those customers as a way to speculate on price movements in the underlying commodity.
This statutory presumption would not affect either the interbank currency market or already regulated instruments like securities and banking products. It would, however, ensure that scammers cannot tailor their written agreements to sell leveraged commodity products to retail customers for speculative purposes in a completely unregulated environment. Moreover, it protects retail customers by giving the CFTC the power to shut down unregulated boiler rooms and freeze their funds.
While NFA continues to believe that the solution to Zelener should go beyond forex, we recognize that H.R. 4473's narrow Zelener fix would be a marked improvement over the current state of the law. If Congress adopts only a narrow Zelener fix and boiler rooms move to other commodities using Zelener-type contracts, then Congress must be willing to re-open the Act before the next reauthorization to consider resolving this issue completely.
In closing, let me state that NFA believes the industry and the public have benefited greatly from the enlightened regulatory approach that Congress adopted in the CFMA and from the CFTC's role in implementing the Act. We look forward to working with this Subcommittee, other Congressional committees, the CFTC, and the industry to address the important customer protection issues outlined above.