Overview
Yesterday, the US Commodity Futures Trading Commission's (CFTC) Division of Swap Dealer and Intermediary Oversight, and Division of Clearing and Risk (together, the Divisions) jointly issued (1) new no-action relief and advisory guidance on the requirements of Rule 1.56 for separate accounts; and (2) an extension of time for existing no-action relief of Rule 39.13(g)(8)(iii) concerning futures commission merchant (FCM) margining practices for customers with separate cleared derivatives accounts. Staff Letter 20-28 supplements past relief and advisory guidance previously announced in Staff Letter 19-17 (July 10, 2019) and the Division directors' Statement Concerning the Treatment of Separate Accounts of the Same Beneficial Owner (September 13, 2019).
Letter 20-28 is the latest chapter in CFTC oversight of FCMs that goes back over six years, when the Joint Audit Committee (JAC) issued JAC Alert 14-03 (May 21, 2014) that reminded FCMs that "all accounts of the same beneficial owner within the same regulatory account classification . . . should be combined for margin purposes."
To learn more about this topic, including best practices for demonstrating compliance, see Steptoe's Margin Treatment of Separate Accounts: Complying with Regulatory Requirements.
Below are eight key takeaways from Letter 20-28:
1. The Divisions granted Rule 1.56 no-action relief for six months – until March 31, 2021.
Letter 19-17 did not provide per se no-action relief from Rule 1.56, which has been in place for decades and prevents an FCM from representing that it will limit or guarantee against customer loss. Rather, Letter 19-17 merely served as an advisory for this regulation, confirming what Rule 1.56 requires of FCMs. Further, the Division directors' statement told derivatives clearing organizations (DCOs), FCMs, and their customers that registrants were expected to come into compliance with Rule 1.56 no later than September 15, 2020, and that the Divisions "will not be extending this timeline at any point."
However, Letter 20-28 provides specific relief for FCMs with customer agreements not yet in compliance with Rule 1.56. Letter 20-28 cites both the "extraordinary difficulties created by the COVID-19 Pandemic" and "consequent difficulties FCMs may have encountered" as reasons for the granting of the relief until March 31, 2021.
2. Market participants must review and revise customer agreements before March 31, 2021, or risk an enforcement proceeding.
Letter 20-28 reinforces the prospect that the JAC and the Divisions may begin examining for compliance with Rule 1.56 next year and could not be clearer about the risks of noncompliance with Rule 1.56: "any cases where either of the Divisions learns or finds that an FCM is not in compliance with Regulation 1.56 will be referred to the Division of Enforcement." Even if there is a change in CFTC leadership in the future, the probability that the Divisions will grant further extensions appears low. Accordingly, while some FCMs have done sample size reviews of customer clearing agreements, market participants should begin reviewing all agreements now to minimize possible future compliance liability.
The Divisions make clear in Letter 20-28 that "[t]here is no specific or express language that must be contained in customer agreements . . . ." Industry groups like the Futures Industry Association (FIA) and the Securities Industry and Financial Markets Association’s Asset Management Group have developed sample contractual provisions for standardized language for clearing agreements where an FCM has separate accounts of the same beneficial owner.
3. The Divisions will consider and might credit legal analysis from FCM outside counsel.
In cases where customer agreements retain provisions that remain ambiguous with respect to Rule 1.56 compliance, the Divisions encourage FCMs to mitigate legal risk by, among other things, obtaining legal opinions or "well-reasoned" memorandum(a) from outside counsel confirming the customer agreements do not violate Rule 1.56.
4. Unilateral FCM disclosure (without customer acknowledgment?) cures a violative clearing agreement provision.
The Divisions take the position that clearing agreements with offensive provisions related to the guarantee against or limit against customer loss can be unilaterally revoked. Letter 20-28 indicates that when an FCM "promptly . . . sends a written disclosure to the beneficial owner" that the customer cannot rely on those representations, such steps "will be considered as an effective cure) [sic]."
Letter 20-28 does not indicate whether the FCM disclosure needs to be acknowledged or agreed to by the customer, but implies that customer acknowledgment or agreement is not required. Additionally, Letter 20-28 does not provide specific disclosure language, but is clear that disclosure must be made no later than March 31, 2021.
5. Customer agreements cannot guarantee against or limit customer loss, but can be silent on the issue.
A number of questions have been raised around whether FCM clearing agreements must explicitly prohibit guarantees against or limit customer loss. Letter 20-28 provides that customer agreements silent on this issue "would meet the requirements of Regulation 1.56" and "an FCM need not have additional provisions regarding its rights against the beneficial owner."
6. "Rainy day" contractual provisions are permitted.
Letter 20-28 permits "a protocol to address rare occasions where margin calls in one account of the beneficial owner at the FCM are not timely met." In other words, customer clearing agreements may include "a specific series of defined steps," such as contacting the beneficial owner of the account with a margin deficit, before liquidating funds in other accounts of the beneficial owner at the FCM. The Divisions remind market participants, however, that FCMs must retain discretion on whether and when to liquidate accounts to access necessary funds.
7. The JAC examinations should be put on hold.
Letter 20-28 is explicit that the Divisions "urge self-regulatory organizations to take similar action" with respect to an extension of time before examining and penalizing FCMs for noncompliance with Rule 1.56.
This is important because, despite the relief provided by Letter 19-17 and the Division directors’ year-long reprieve issued in September 2019, a number of FCMs continue to receive and respond to inquiries for copies of customer agreements as part of an effort to examine for compliance with Rule 1.56 and Rule 39.13(g)(8)(iii). The Divisions make clear in Letter 20-28 that those workstreams should wait until the new March 31, 2021 deadline passes.
8. Rule 39.13(g)(8)(iii) relief is extended through the end of 2021.
Letter 20-28 extends Rule 39.13(g)(8)(iii) relief through December 31, 2021. The Divisions note that they "will consider further extension of this timeframe" if the next 15 months proves to be insufficient time "for Staff to recommend, and the Commission to determine, whether to conduct . . . a rulemaking to implement appropriate relief on a permanent basis."
What's Next?
As discussed, market participants have notice from the Divisions that they have six months to analyze existing customer agreements. Parties can look to industry-sourced materials and bring the contracts into compliance with Rule 1.56 or take steps to mitigate legal risk, such as seeking an assessment from outside counsel.
FCMs may consider sending disclosure to customers clarifying how the intermediary will treat a margin deficit in one account by looking to other accounts held by the same beneficial owner.
Customers may engage with their FCMs now to resolve any potential ambiguities in their relationship documents that may be unilaterally addressed by a disclosure document.