9041 - OBLIGATIONS TO CUSTOMERS AND OTHER MARKET PARTICIPANTS
(Board of Directors, August 21, 2001; revised September 10, 2001)
The Commodity Futures Modernization Act of 2000 (CFMA), which was signed into law on December 21, 2000, lifts the 18-year ban on single-stock futures and narrow-based security indices ("security futures products"). Unlike other futures contracts, however, the CFMA provides that security futures products are securities as well as futures. Therefore, under Section 15A(k) of the Securities Exchange Act of 1934 (Exchange Act), NFA is a national securities association (NSA) 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 Act (i.e., FCMs and IBs who "passport" in to broker-dealer registration because they limit their securities activities to security futures products).
Since NFA is a registered futures association, the Commodity Exchange Act requires it to have rules designed to promote fair dealing with customers and other market participants for all futures contracts, including security futures.1 Since NFA is a limited purpose NSA, the Exchange Act also requires it to have rules that are designed to promote fair dealing for security futures products.2 All of NFA's rules apply to activities involving security futures products. However, certain additional requirements apply to activities in security futures products by Members registered as broker-dealers under Section 15(b)(11) of the Exchange Act and their Associates.
NFA Compliance Rule 2-4 requires all Members and Associates to observe high standards of commercial honor and just and equitable principles of trade in the conduct of their commodity futures business. This includes a requirement to deal fairly with customers and other market participants at all times. This interpretive notice reminds all Members and Associates of their obligation not to trade ahead of customer orders in any commodity. It also discusses those fair dealing obligations that are unique to security futures products.
Trading Ahead of Customer Orders
CFTC Regulations 155.3 and 155.4 — which are incorporated into NFA rules through Compliance Rule 2-26 — require FCMs and IBs to establish and enforce internal rules, procedures, and controls to insure, to the extent possible, that those firms and their employees do not trade ahead of customer orders that are executable at or near the market price. Literally read, those regulations require procedures but do not contain an outright prohibition on trading ahead. However, knowingly trading ahead of customer orders in any commodity violates NFA Compliance Rule 2-4, which requires Members and Associates to observe high standards and just and equitable principles of trade.
Further, Compliance Rule 2-4 also requires Members and Associates to exercise due care to avoid trading ahead of customer orders. Members and Associates will be considered to be exercising due care if they do not know or should not reasonably have known of the customer order. For example, absent knowledge, a Member will not be held accountable for trading ahead of customer orders that originate in a different branch office or for proprietary orders that originate in a trading department that does not have access to information regarding customer orders.
Trading Based on Material, Non-Public Information
Other than trading ahead, the Commodity Exchange Act, CFTC regulations, and NFA and exchange rules do not generally prohibit trading futures based on material, non-public information.3 The securities laws, on the other hand, generally do prohibit this conduct. As required by the CFMA, NFA Compliance Rule 2-37(a) prohibits Members registered as broker-dealers under Section 15(b)(11) of the Exchange Act and their Associates from violating Sections 9(a), 9(b) and 10(b) of the Exchange Act and the regulations thereunder in connection with security futures products. Insider trading and other forms of trading based on material, non-public information that are violations of SEC Rule 10b-5 would also be violations of NFA Compliance Rule 2-37(a).4
Members registered as broker-dealers under Section 15(b)(11) of the Exchange Act and their Associates may not purposefully establish, increase, decrease, or liquidate a position in any security futures product in anticipation of the issuance of a research report regarding the underlying security or a derivative based primarily upon the underlying security (including the security futures product itself). Members should consider developing and implementing firewalls to isolate specific information within research and other relevant departments of the firm so as to prevent the trading department from utilizing the advance knowledge of the issuance of the research report. Firms that choose not to develop these firewalls bear the burden of demonstrating that the change in position was not done in anticipation of the issuance of the report.
It shall be considered conduct inconsistent with just and equitable principles of trade for a Member registered as a broker-dealer under Section 15(b)(11) of the Exchange Act or an AP of such a Member, acting for an account in which such Member or AP has an interest, for an account with respect to which such Member or AP exercises investment discretion, or for certain customer accounts, to cause to be executed:
(a) an order to buy or sell a security futures product when such Member or AP causing such order to be executed has material, non-public market information concerning an imminent block transaction in the underlying security, or when the customer has been provided such material non-public market information by the Member or AP; or
(b) an order to buy or sell an underlying security when such Member or AP causing such order to be executed has material, non-public market information concerning an imminent block transaction in a security futures product overlying that security, or when the customer has been provided such material, non-public market information by the Member or AP;
prior to the time information concerning the block transaction has been reported to the exchange.5
The violative practice noted above may include transactions which are executed based upon knowledge of less than all of the terms of the block transaction, so long as there is knowledge that all of the material terms of the transaction have been or will be agreed upon imminently. A Member will not, however, violate this requirement if it has exercised due care to avoid trading on that information and the individual or individuals causing the order to be executed do not know and should not reasonably have known about the imminent block transaction.
The general prohibitions stated above shall not apply to transactions executed by member participants in automatic execution systems in those instances where participants must accept automatic executions. These prohibitions also do not include situations in which a Member or AP receives a customer's order of block size relating to both security futures product and the underlying security. In such cases, the Member and AP may position the other side of one or both components of the order. However, in these instances, the Member and AP would not be able to cover any resulting proprietary position(s) by entering an offsetting order until information concerning the block transaction involved has been reported to the exchange.
Additionally, a contract market or derivatives transaction execution facility may have a specific rule that permits block transactions that are privately negotiated. Pursuant to these rules, a block transaction must be reported to a designated exchange official and/or the exchange's clearing house within a specified time period after execution of the block transaction. During this time period after execution but prior to reporting, Member firms that are a party to the block transaction have a legitimate need to hedge their own risk exposure. Therefore, the general prohibitions stated above shall not apply to transactions executed by Member firms if done in conjunction with hedging the Member firm's own risk in a block transaction executed under the applicable rules of a contract market or derivatives transaction execution facility.
A transaction involving 10,000 shares or more of an underlying security or security futures product covering such number of shares is generally deemed to be a block transaction, although a transaction of less than 10,000 shares could be considered a block transaction in appropriate cases. A block transaction that has been agreed upon does not lose its identity as such by arranging for partial executions of the full transaction in portions which themselves are not of block size if the execution of the full transaction may have a material impact on the market. In this situation, the requirement that information concerning the block transaction be reported to the exchange will not be satisfied until the entire block transaction has been completed and reported to the exchange.
Communications with the Public
Under NFA Compliance Rules 2-4 and 2-29(a)(1), all communications with the public regarding security futures products must be based on principles of fair dealing and good faith and no material fact or qualification may be omitted if the omission, in the light of the context of the material presented, would cause the communication to be misleading. Furthermore, Members registered under Section 15(b)(11) of the Exchange Act and their Associates should provide a sound basis for evaluating the facts regarding any particular security futures product, including facts regarding the underlying security, industry, or group of securities.
1See Section 17(b)(7) of the Commodity Exchange Act (7 U.S.C. 21(b)(7)).
2See Section 15A(k)(2)(B) of the Securities Exchange Act of 1934 (15 U.S.C. 78o-3(k)(2)(B)).
3CFTC Regulation 1.59 prohibits self-regulatory organization board and committee members from using or disclosing material, non-public information obtained as part of their service on the board or committee. Depending on the circumstances, Members and Associates may also violate a fiduciary obligation by trading on material, non-public information obtained from their customers or employer or making use of information that the Member or Associate knows was wrongfully disclosed.
4Although Compliance Rule 2-37(a) applies only to Members registered as broker-dealers under Section 15(b)(11) of the Exchange Act and their Associates, all Members and Associates are subject to the securities laws in connection with their security futures activities. Violating any law that applies to a Member or Associate's futures business — including securities laws that apply to security futures activities — is conduct inconsistent with just and equitable principles of trade under NFA Compliance Rule 2-4.
5Commodity pool operators and commodity trading advisors who engage in similar conduct would violate NFA Compliance Rule 2-4 if they abuse their fiduciary relationship with pool participants or clients.