Proposed Rule

As you know, the Commodity Futures Modernization Act of 2000 (CFMA) prohibits retail transactions unless the counterparty is a regulated entity such as a bank, a broker-dealer, or an FCM (or certain of their affiliates), and it applies the anti-fraud provisions to those transactions if the counterparty is an FCM, an FCM affiliate, or an unregulated entity.¹⁴

After Congress passed the CFMA, a number of firms registered as FCMs and became NFA Members so they could offer retail forex. Since most of NFA's rules apply only to transactions that occur on an exchange, NFA created a new membership category for "Forex Dealer Members" (FDM) and adopted separate rules to govern their off-exchange retail forex futures and options transactions. The FDM category includes most registered FCMs formed specifically to engage in these transactions but does not include broker-dealer FCMs that are members of NASD or FCMs that do not themselves act as counterparties. As of September 30, 2006, NFA had approximately 40 active Forex Dealer Member FCMs, and they held approximately $770 million in customer funds.

Although Congress attempted to clarify the CFTC's jurisdiction over retail foreign currency futures and options transactions, the Commission's authority is still uncertain, due in large part to the Seventh Circuit's decision in CFTC v. Zelener.¹⁵ As a result of the Zelener decision and its progeny, the CFTC's jurisdiction over certain types of speculative retail off-exchange products that walk, talk, and act like futures contracts is unclear.¹⁶

CFTC Reauthorization Legislation Regarding Retail Forex

As you are aware, Congress is attempting to resolve this issue. H.R. 4473 was passed by the U.S. House of Representatives and sent to the Senate, where it is currently pending. The House bill incorporates language recommended by the President's Working Group (PWG).

The House legislation continues to permit off-exchange retail forex futures and options transactions with certain otherwise regulated counterparties, including FCMs and their affiliates, and it also continues to give the CFTC anti-fraud authority over transactions where the counterparty is an FCM only, an affiliate of an FCM only, or an unregistered person. Therefore, if a court classifies a retail forex transaction as an off-exchange futures contract or option, the counterparty limitations will apply.

The legislation does not limit the entities who can act as counterparties to Zelener-type retail forex transactions, however, although it does extend the CFTC's anti-fraud jurisdiction to these transactions if an FCM only, an affiliate of an FCM only, or an unregulated person is the counterparty. In general, the legislation applies to speculative, leveraged retail forex transactions but not to hedging activities or transactions entered into for delivery.

The House bill (and the PWG language) also includes a savings clause stating that this provision does not limit the CFTC's jurisdiction over any contract of sale of a commodity for future delivery. NFA anticipates that, except for the energy provisions, the final Senate legislation will be similar to the House bill and will include the same forex-only solution to the Zelener issue. At this time, however, floor action has not yet been scheduled in the Senate.

All signs currently point to Congress adopting the amendments recommended by the PWG. At this time, however, it is unknown as to when Congress will complete the CFTC reauthorization legislation.

NFA's Jurisdiction Over Members Selling Zelener-Type Forex Products

Since the timetable for reauthorization is unclear, NFA considered several approaches to assert jurisdiction over Zelener-type transactions and determined to amend its forex rules to replace the references to futures and options with the PWG's language regarding leveraged forex transactions. This will clarify now that Zelener-type forex transactions are within NFA's jurisdiction, and it will not rely on reauthorization to do so.

In particular, the amendments adopt a new section (b) to Bylaw 1507 to define "forex" using the PWG language and to find retail forex to be a proper subject of NFA regulation and oversight; incorporate that definition into NFA's other forex requirements by reference; and eliminate language made superfluous by the new definition. The proposed amendments also revise the introductory language to the Interpretive Notice to make it consistent with the revised definition.

There are no legal impediments to this approach, even if taken before Congress passes the reauthorization legislation (or even in the unlikely event that Congress never passes the forex provisions). The CFTC's authority and NFA's authority come from two different sources, and NFA's authority is actually broader than the CFTC's when it comes to regulating its Members' activities.¹⁷

The CFTC's authority comes from the CEA while NFA's authority - like that of other self-regulatory organizations - comes from its contractual relationship with its members.¹⁸ The terms of that contract are found in NFA's Articles of Incorporation and the requirements NFA adopts under those Articles.¹⁹

Article III authorizes NFA to "promote the improvement of business conditions and the common business interests of persons engaged in commodity futures or related activity" by regulating its Members, and Article XVIII(k) defines "futures" to include "such other commodity-related instruments as the Board may from time to time declare by Bylaw to be properly a subject of NFA regulation and oversight."²⁰ Article III goes on to authorize NFA to adopt, administer, and enforce requirements as to Members regarding fair practice, to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, and in general to protect the public interest. These provisions clearly allow NFA to regulate the activities of its Members who solicit, recommend, or act as counterparty to leveraged off-exchange forex transactions with retail customers for purposes of speculation.

Finally, the Board adopted several technical changes to clarify the existing forex requirements. Those changes:

• Clarify that Compliance Rule 2-39 applies to Associates soliciting or managing forex accounts even when those activities are not conducted on behalf of an NFA Member;
• Clarify that the concentration charge includes customer positions;
• Modify current footnotes 5 and 13 of the Interpretive Notice to conform to Compliance Rule 2-39;
• Clarify that Forex Dealer Members are responsible for all their forex affiliates, including assuring that those affiliates do not engage in forex transactions unless they are authorized to do so under the Act; and
• Make a technical amendment to Financial Requirement Section 12 to update a rule reference.

¹⁴ The term "affiliates" refers to those entities described in Section 2(c)(2)(B)(ii)(III) of the Act.

¹⁵ CFTC v. Zelener, 373 F.3d 861 (7th Cir. 2004).

¹⁶ Those progeny include a district court case in the Sixth Circuit that relied heavily on Zelener. See CFTC v. Erskine, Case No. 1:04CV16 (N.D. Ohio, April 17, 2006).

¹⁷ Obviously, NFA is also subject to Section 17 of the CEA and implementing regulations, but these requirements are not the sole source of NFA's authority over its Members.

¹⁸ "The constitution and rules of a stock exchange constitute a contract between all members of the exchange with each other and with the exchange itself." Coenen v. R.W. Pressprich & Co., Inc., 453 F.2d 1209 (2nd Cir., 1972).

¹⁹ The 7th Circuit cited this contract as the source of NFA's authority when it upheld NFA's arbitration rule compelling an NFA Associate to arbitrate a dispute with an NFA Member - a rule that is not required by the CEA and has no parallel in the Commission's authority under the CEA (which authorizes reparation proceedings for customer claims but not for business disputes between registrants). R.J. O'Brien & Assoc., Inc. v. Pipkin, 64 F.3d 257 (7th Cir. 1995).

²⁰ The NFA Interpretive Notice entitled "Forex Transactions With Forex Dealer Members" currently states in footnote 3: "The Board of Directors has determined that the retail, off-exchange forex transactions entered into by these firms should be subject to NFA's regulatory jurisdiction and are a proper subject of NFA regulation and oversight under Article XVIII(k) of NFA's Articles of Incorporation." The Board is moving this determination to Bylaw 1507.