The Commission denied BondGlobe's request for a no-action letter. (See id at 1). In support of its belief that BondGlobe is acting as a broker-dealer, the Commission cites the fact that BondGlobe is paid for communicating customer orders, that it matches customer orders, that it conveys information to the parties to begin the clearing and settlement process, and that it conducts auctions and reverse auctions. (See id at 3). Furthermore, the Commission found that the BondGlobe site allowed users to apply for brokerage accounts and register existing accounts with BondGlobe, thus negating BondGlobe's statement that it would not solicit investors. (See id at 4). In addition, BondGlobe's site also allows public customers to check their accounts, and enter and modify orders. (See id at 5). Finally, BondGlobe advertises its service by noting that "brokers can reduce the level of customer support and still provide a better investing experience to their clients (emphasis added)." (Id). These factors indicate that BondGlobe is acting as a broker-dealer and must register as such.
In April of 2001, Prescient Markets, Inc. (Prescient) requested a no-action letter from the Commission to ensure that it would not have to register as a broker-dealer if it introduced an "Internet-based, electronic platform (Platform) for commercial paper." (Prescient Markets, Inc., 2001 SEC No-Act. LEXIS 464 (Apr 2, 2001) at 9 [hereinafter Prescient]). The purpose of this Web site would be to "help direct issuers of and institutional investors in commercial paper interact more efficiently by harnessing the usefulness and convenience of the technological developments taking place in the financial services industry." (Id at 12). To use the Platform, direct issuers of commercial paper would post their current rates and investors would be able to view current rates and user information. (See id at 13). Investors would then be able to submit buy orders or a notice of interest in specific issues. (See id). Negotiations could also be performed via the Platform. (See id at 13). Although this Web site seems similar to the one operated by Bond Globe, it differs in that Prescient Securities LLC, a registered broker-dealer, will operate the Web site and Prescient's only role will be to provide the software and system technology for the site and to provide ongoing maintenance of the site; all other functions will be performed by the registered broker-dealer. (See id at 14). In addition, only approved investors will have access to the site, which will be password protected. (See id at 17). Finally, Prescient's compensation will be a percent of the dollar amount of commercial paper that has been posted on the Platform during the billing cycle. (See id at 24).
The Commission granted the no-action letter. (See id at 2). Specifically, the Commission took note of the following: that fees would not be dependent on the size or number of transactions; that payment was being made only for the use of the software and technology; that the registered broker-dealer will be responsible for the activities on the site; and that Prescient would engage in no activities with clients. (See id at 3-5).
Analysis of no-action letters. A review of the no-action letters concerning online financial portals indicates that in certain instances, the Commission will require online financial portals to register as broker-dealers.
In those cases where the Commission issued a no-action letter, the requests had a number of similar characteristics. Most importantly, the firms complied with the four factors enumerated by the courts as activities engaged in by broker-dealers. The first factor was that a broker-dealer receives transaction-based compensation. (See Zubkis, supra note 102, at 9; Hansen, supra note 102, at 10). In all of the situations where no-action letters were granted, the firms were paid a flat fee for their services. (See Angel, supra note 102, at 22; Schwab Two, supra note 102, at 6; Quick, supra note 103, at 4). The second factor is whether or not the firm is engaged in negotiations with the buyer and seller. (See Zubkis, supra note 102, at 9; Hansen, supra note 102, at 10). In all the cases where a no-action letter was granted, the firm did not participate in the negotiations between the buyer and seller. For example, the SBA specifically indicated in its letter that it would post the offerings, but would in no way participate in the interaction between issuer and buyer. (See Angel, supra note 102, at 1). Schwab too set up its plan so that the sites on which its hyperlink would reside would have no participation in the communication between Schwab and its customers. (See Schwab, supra note 102, at 19-20). The third factor is whether the entity is providing investment advice to investors. (See Zubkis, supra note 102, at 9; Hansen, supra note 102, at 10). The firms who received no-action letters all structured their proposals so that the entity not registering as a broker-dealer would not provide investment advice to investors. Quick's Order Management System is merely a conduit for orders and no advising is conducted on its system. (See Quick, supra note 103, at 11). Likewise, the merchants participating in Stockback's plan were limited in what they could even advertise about their participation in the plan and in no way provided investment advise. (See Stockback, supra note 138, at 7-8). The final factor was whether the entity solicited investors actively or passively. (See Zubkis, supra note 102, at 9; Hansen, supra note 102, at 10). Again, the firms receiving a no-action letter structured their plans so that the non-registering entity would not solicit business. Prescient only dealt with the actual platform hardware and software and did not solicit customers. (See Prescient, supra note 159, at 17). Stockback only allowed its merchants to perform limited marketing. (See Stockback, supra note 138, at 7-8). And Schwab did not allow its partners to perform any marketing of its services. (See Schwab, supra note 102, at 19). Other characteristics that defined these letters included the protection of having a related entity as a broker-dealer so that an additional registration would offer only redundant protection. For example, Schwab itself is already registered as a broker-dealer, so customers accessing its site through its partners would be afforded no additional protection since Schwab is already subject to all broker-dealer regulations. (See id at 21). Likewise, Prescient is affiliated with a registered broker-dealer who would handle the usual activities of a broker-dealer and provide investors with regulatory protection. (See Prescient, supra note 159, at 17). Stockback also provided the same redundant protection since it was registered as a broker-dealer. (See Stockback, supra note 138, at 1). Some of the firms that received no-action letters only dealt with pre-approved investors who received password-only access to the site. (See Prescient, supra note 159, at 24; Angel, supra note 102, at 19). Another characteristic the firms shared was that they were all providing passive rather than active services. Quick's Order Management System routed orders, allowed clients to monitor their orders, and receive reports. (See Quick, supra note 103, at 11). In other words, Quick facilitated the flow of information but did not direct the flow of information. (See id at 17). Likewise, the SBA's site was a central posting areas for small business offerings. (See Angel, supra note 102, at 1). It took no active role beyond being an electronic bulletin board. Another feature that is common to all the firms is what they do not do--none of the firms handle customer money, open or service accounts, answer questions, or route trades to particular brokers or markets for execution. (See id; Stockback, supra note 138, at 12). Note that none of the characteristics discussed above are determinative; instead, they are taken together to indicate whether the firm is regularly participating in securities transactions.
In those cases where the Commission declined to provide a no-action letter, there were a number of common characteristics. First, both firms actively matched buyers and sellers. (See MuniAuction, supra note 102, at 3; BondGlobe, supra note 149, at 4). That overt act of choosing the other side of a trade was one of the factors that triggered the broker-dealer registration requirement. Second, both firms heavily advertised for investors. (See MuniAuction, supra note 102, at 4). That activity amounted to holding out to the public as a broker-dealer. BondGlobe particularly held itself out as a service that can perform some customer support services for brokers. (See BondGlobe, supra note 149, at 5). Furthermore, BondGlobe opened and maintained customer accounts. (See id). Another activity that triggered the broker-dealer registration requirement was BondGlobe's participation in the settlement and clearing process. (See id at 4). In sum, these firms were actively engaging in securities transactions from soliciting investors, to opening accounts, to matching buyers with sellers, to initiating the settlement and clearing process. These are not passive activities or services and they trigger the broker-dealer registration requirement.
Conclusion
Because the Internet is the "fastest growing electronic technology in world history," (Cole, supra note 12, at 5). those working with market participants must continue to re-examine old assumptions and work to apply laws, written long before the Internet was developed, to the current technological landscape.
This article has examined which online financial portals should be required to register as broker-dealers. There is no bright line answer. Instead, each situation must be examined on a case-by-case basis. As time consuming as this might be, it is critical that the investing public is protected by working with registered broker-dealers. This protection is so important that careful examination of each unique situation is warranted. The most important factor to look for when making the determination about whether an online financial portal should register is to look at the portal's relationship with its customers. Whenever an online financial portal assumes any decision-making or advisory role, it must register. Those portals that are merely conduits of information or passively conduct communications without making any decision for the clients should not be required to register. This may be a fine line, but it is critical that any portal that plays any active role in securities transactions be required to register. Some critics may argue that more regulation will push some players out of the market, will limit the choices investors have, and will be more expensive for investors. This does not need to be the case. As seen in the no-action letters reviewed in this article, many firms are able to structure their online portals so that there is a "wall" between the customer and portal, thus avoiding the broker-dealer registration requirement. By requiring firms to carefully design their products so as to ensure that their products are not inadvertently assuming a broker-dealer role, investors get the benefit of being able to use the most advanced technology while at the same time enjoying the protection of the federal securities laws. This gives investors the best of both worlds with little additional burden on firms.
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Ana M. Mencini holds a J.D. from the Chicago-Kent College of Law, an M.A. in Writing from DePaul University, and a B.A. in English from Lake Forest College. Prior to attending law school, Ms. Mencini worked in the financial industry. Currently, Ms. Mencini is a Case LAW EDitor for LexisNexis Group.
Security futures: The "state of the union"
By Randy Tuurie
Introduction
The objective of this article is to trace the recent history of security futures and examine the current regulatory scheme that governs them, focusing particularly on the role of the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC).
For the purposes of this article, the term "security future" encompasses both single-stock futures and narrow-based security indices. As defined in the Commodity Futures Modernization Act of 2000 (CFMA), a single-stock future is a "contract of sale for future delivery of a single security or of a narrow-based security index."1 A "narrow-based security index" is defined as an index that contains nine or fewer stocks on companies in the same industry.2
History of security futures regulation
The SEC and CFTC have long disputed jurisdiction over particular securities, and security futures are no exception.3 The assignment of the regulation of securities to the SEC and the regulation of futures to the CFTC is a political, not an economic, division.4 As hybrid financial products have increased in popularity, the politically based assignment of securities regulation to either the SEC or CFTC has magnified friction between the agencies. 5
According to the Securities Act of 1933 and Securities Exchange Act of 1934 (Exchange Act), the SEC has jurisdiction over "any put, call, straddle option, or privilege on any security."6 Thus, although security futures are not specifically mentioned as part of the SEC's jurisdiction, the SEC can claim jurisdiction over security futures both because the underlying securities are stocks and because trading in security futures could impact the securities and options markets.7
According to the Commodity Exchange Act (CEA), the CFTC has "exclusive jurisdiction... with respect to... transactions involving contracts of sale of a commodity for future delivery."8 Since security futures involve contracts of sale of a stock for future delivery, the CFTC can claim jurisdiction over them.9 To make matters even more complex, the CFTC is required to "consult with the [SEC] with respect to... any contract of sale... for future delivery of a group or index of securities."10
Shad-Johnson and the ban on security futures
When Congress attempted to create a framework to trade security futures in 1982, the SEC and CFTC could not agree on a regulatory plan because of jurisdictional conflicts.11 Consequently, Congress simply prohibited trading in security futures in the "Shad-Johnson Accord" of 1982, which was named after then-chairman of the SEC (John Shad) and the head of the CFTC at the time (Philip MacBride Johnson).12 In Johnson's words, "no one was hankering after [security futures], and I was not prepared to cede any jurisdiction to anyone over any kind of futures contract." 13 While passing on the issue of security futures, the Accord gave the SEC the authority to regulate security-based options, and the CFTC the authority to regulate contracts on broad-based stock indexes and individual government securities.14
The ban on security futures was meant to be temporary, until the SEC and CFTC could reach a regulatory agreement.15 Yet it was not until 18 years later, after the political climate became favorable to financial market reform, that the ban was finally lifted.16
Passage of the Commodity Futures Modernization Act
Hailed as "a major achievement by the 106th Congress" by Senator Phil Gramm, the CFMA removed the ban on security futures (among other things).17 Senator Peter Fitzgerald stated that the CFMA established a regulatory framework that "will remove impediments to innovation and regulatory barriers to fair competition for the United States financial markets."18 The CFMA modified the definitions sections of the CEA and the Exchange Act to incorporate security futures and security futures indices, and also modified the CEA and Exchange Act to repeal the Shad-Johnson Accord's ban on security futures trading. 19
Although Congress had been interested in reforming the futures industry for several years, the enacted statute has been viewed with skepticism in some quarters.20 Since the bill passed hours before Congress adjourned, without comment or debate, the approval process itself "raised some eyebrows."21 Also, as the London International Financial Futures and Options Exchange (LIFFE) prepared to trade security futures on U.S. stocks in 2000, Chicago's futures exchanges exerted pressure on Congress to pass the bill by articulating fears that the LIFFE would dominate the market on security futures if security futures were not traded on American exchanges.22 As a result, the CFMA was viewed as "cobbled together" by Chicago's financial exchanges by some observers.23
Regulatory issues presented by security futures
The unique characteristics of security futures creates particular advantages and disadvantages for investors, which in turn creates distinct regulatory issues for the SEC and CFTC. Regulating a security as a futures contract and as a security is unprecedented in the United States, and requires lawyers and compliance officers to consider both SEC and CFTC regulations.24
Advantages of security futures
There are a number of advantages associated with security futures, as well as a number of causes for concern. In general, trading in security futures (as well as any derivative) has three primary advantages over trading the underlying security: greater leverage, improved liquidity, and a reduction in transaction costs.25 Shorting stock using security futures is much easier than using instruments currently available, which gives individual investors a hedging advantage previously reserved for institutional investors.26 Also, security futures can lead to additional price discovery, which gives investors further information about securities' market value (price discovery, in this case, occurs by purchasers of futures speculating on a stock's price outlook, or on expectations about dividends).27
Disadvantages of security futures
The lower costs and margin requirements of security futures, which is a boon for institutional investors, could expose small investors to risk by allowing easier access to excessive speculation.28 Additionally, small investors also may not be adequately educated about the risks of security futures when they buy them.29
Regulatory response: Margin requirements
Security futures offer lower costs than trading either the underlying security or an option.30 Purchasing a future does not require producing the full cost of the underlying security, because only a portion of the cost is required to initiate the contract (margin).31 Creating the equivalent of a future contract on a single stock with options is also expensive because such an endeavor would involve the purchase of a call, sale of a put, and a lending transaction.32 The lower costs of security futures make them attractive for major traders, such as investment firms and hedge funds, because it will lower their costs.33
The CFMA specifies that margin levels for security futures cannot be lower than the lowest margin level of "comparable" securities products.34 The CFMA delegates margin-setting power to the Federal Reserve, which could subsequently delegate the power to the SEC and CFTC (which the Federal Reserve has done).35 A margin requirement on the purchase of individual securities is 50 percent, and futures transactions typically only require a margin of a few percent.36 The SEC and CFTC have both enacted mandatory margin amounts on security futures trading of 20 percent.37 The required margin was both a middle ground between stock and futures margin requirements, and a competitive rate with foreign exchanges trading security futures.38 In addition, the SEC has proposed a rule to allow broker-dealers to include margin for security futures as a debit item in calculating customers' reserve requirement.39
Other regulations
The CFMA allows security futures to be traded on both securities and options exchanges, but requires exchanges that do so to register with the SEC and CFTC.40 The SEC has also recently promulgated rules to protect investors by requiring the settlement price of security futures to "fairly reflect the opening price of the underlying security or securities," and by requiring broker-dealers and futures commission merchants to disclose specific information about the securities laws affecting security futures to customers.41
Conclusion
OneChicago LLC announced that it successfully began trading security futures on November 8, 2002.42 The Nasdaq and LIFFE are trading security futures through a joint system (called NQLX).43 Island Futures Exchange LLC also has a designation to trade security futures, and the American Stock Exchange is expected to set up its own market as well.44 So far, security futures trading accounts for about one percent of the total trading volume of the index futures market.45 Security futures' prospects are uncertain--but in the words of T. Eric "Rick" Kilcollin, former president of the Chicago Mercantile Exchange, "I think the hype has been awfully overblown."46
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Randy Tuurie is a third-year evening student at Chicago-Kent College of Law. E-mail him at rtuurie@kentlaw.edu.
1. H.R. 5660 106th Cong. §201 (2000).
2. Id. at §101.
3. Benson, John D., Ending the Turf Wars: Support for CFTC/SEC Consolidation, 36 Vill. L. Rev. 1175, 1185 (1991) (disputes between the SEC and CFTC "date back to the very dawn of the CFTC's existence"); see Board of Trade, v. SEC, 187 F.3d 713, 716-717 (7th Cir. 1999) (case where tensions between the SEC and CFTC manifested themselves in a dispute over which agency had jurisdiction over options on government-backed mortgage certificates).
4. Board of Trade v. SEC, 187 F.3d 713, 716 (7th Cir. 1999).
5 A Dictionary of Finance and Banking 167 (Brian Butler et al. eds., 2nd ed., Oxford University Press 1997) (hybrid security products are "synthetic financial instruments formed by combining two or more individual financial instruments").
6. 15 U.S.C. §78(a)(10) (1994).
7. Nina Mehta, Get Ready for Single-Stock Futures, Derivatives Strategy July 2000.
8. 7 U.S.C. §2(iv) (1994).
9. Vanessa Blum, Uncertainty Over New Stock Product: SEC, CFTC Pressured to Clarify Rules for Single-Stock Futures, Legal Times 1 (Aug. 20, 2001) ("[security futures are] subject to regulation as a futures contract and a security").
10. 7 U.S.C. §2(iv)(I).
11. Fine, Sanford A., Back to the (Single Stock) Future: The New Regulatory Framework Governing Single-Stock Futures Trading, 54 Admin. L. Rev. 513, 521-22 (Winter 2002).
12. 7 U.S.C. §2a(ii)(II)-(III) (1994); see Blum, Legal Times at 1.
13. Mehta, supra, n.7.
14. Esau, David B., Joint Regulation of Single Stock Futures: Cause or Result of Regulatory Arbitrage and Interagency Turf Wars?, 51 Cath. U.L. Rev. 917, 921-22 (2002).
15. Id. at 922.
16. Mehta, supra, n.7; see also Douglas Harbrecht, Goodbye Glass-Steagall, Hello Big Mergers - and Big Fees? Business Week Online (Oct. 29, 1999) <http://www.businessweek.com/bwdaily/dnflash/oct1999/nf91029b.htm?scriptFramed> ("[politicians] have reached agreement on repealing the outdated Depression-era Glass-Steagall laws that kept the banking, insurance, and securities businesses separate.").
17. 146 Cong. Rec. S11, 866-68 (daily ed. Dec. 15, 2000).
18. Id. at 878.
19. Pub. L. No. 106-554 tit. I, §101, 114 Stat. 2763A (2000) (provides for including security futures in the CEA and Exchange Act and amends the CEA and Exchange Act to encompass security futures); see 7 U.S.C. §1a (1994) (definitions used in the CEA); see also 15 U.S.C. 78c (1994) (definitions used in the Exchange Act).
20. Hill, Richard, Work on Reforming Futures Industry Regulation to Continue in 2002, 34 Securities Regulation & Law Report 142 (January 28, 2002).
21. Partnoy, Frank, Some Policy Implications of Single-Stock Futures, Futures & Derivatives Law Report 8 (March 2001).
22. Financial; Breakfast Briefing; Nation World, Chicago Sun-Times 57 (Sept. 21, 2000); see An Uncertain Future, Chicago Sun-Times 43 (Sept. 22, 2000) ("exchanges in Chicago will be at a competitive disadvantage from which they may never recover").
23. Fine, 54 Admin. L. Rev. at 530; see also 146 Cong. Rec. S11 at 879 (statement of Senator Peter Fitzgerald, from Illinois, asserting that "the positive impact of this legislation on Chicago's futures markets cannot be overstated.").
24. Blum, Legal Times at 1 (statement of Stuart Kaswell, general counsel of the Securities Industry Association, stating that "[w]e've never seen [regulation of a security as a futures contract and as a security] before"); see Mehta, supra, n.7 (statement of Philip McBride Johnson, "[i]f futures contracts are regulated based on the asset they track, then the industry will be faced with scores of different regulators.... it would be a very, very big setback for the industry and a huge cost ever to buy into the argument that you choose the regulator by the underlying asset.").
25. Davidson, John P., Operations Issues for U.S. Single Stock Futures, Futures & Derivatives Law Report at 1 (June 2001); see Karol, Bernard J. and Lehman, Mary B. Equity Derivatives, S&P's The Review of Securities & Commodities Regulation 121 (July 1994) ("investors with large concentrations of a single stock equity instruments... frequently experience problems of diversification and liquidity").