in a futures contract transaction. Indeed, only since April 1975, when the CFTC Act became effective, has a regulatory agency had jurisdiction over these transactions. I should point out also that, unlike the case with respect to futures transactions, nowhere in the CE Act or in the CFTC Act has Congress stated the terms and conditions under which these transactions may take place or provided for the segregation of customer funds. Rather, Congress has expressly directed the CFTC to make these determinations through adoption of appropriate regulations. Naturally, the adoption of a definitive regulatory program in these two areas cannot occur without the CFTC engaging in a self-educational process through an exhaustive inquiry into how these transactions work, an inquiry which, as I will explain in more detail shortly, is only now reaching its completion. In this connection, I believe it significant that Congress gave the CFTC a full year to study, and to adopt regulations governing, commodity option transactions, and if more time was needed, authorized the CFTC to inform Congress of that fact. The CFTC has so informed the Congress.

Accordingly, Mr. Chairman, the CFTC's recommendations concerning the amendments to the Bankruptcy Act as they relate to commodity option transactions and leverage transactions will, of necessity, be more general in nature than those regarding futures contracts and the bankruptcy of futures commission merchants and clearing houses. Nevertheless, the basic thrust of these recommendations is the same: the CFTC regards its segregation requirements as the cornerstone of the protections afforded commodity customers in transactions subject to its jurisdiction and believes that the Bankruptcy Act must be amended to give full recognition to these requirements if the CFTC determines that they should apply to commodity option transactions and/or leverage transactions. At this time, I will endeavor to outline the issues confronting the CFTC in commodity option transactions and in leverage transactions which I believe warrant the implementation of its recommendations.

COMMODITY OPTION TRANSACTIONS

Section 4c (a) (B) of the CE Act, 7 U.S.C. 6c (a) (B), expressly forbids option transactions relating to those commodities which were regulated under the CE Act prior to the enactment of the CFTC Act," thereby continuing the CE Act's prohibition with respect to those commodities, traditionally domestic agricultural commodities.

The authority of the CFTC to regulate options involving commodities that are newly regulated by virtue of the CE Act's expanded definition of the term "commodity"," is contained in section 4c (b) of the CE Act, 7 U.S.C. 6c (b), which provides that no person shall offer to enter into, enter into, or confirm the execution of, any transaction [involving a newly regulated commodity] . . . which is of the character of, or is commonly known to the trade as, an "option", "privilege", "indemnity", "bid", "offer", "put", "call", "advance guaranty", or "decline guaranty", contrary to any rule, regulation, or order of the Commission prohibiting any such transaction or allowing any such transaction under such terms and conditions as the Commission shall prescribe within one year after the effective date of the Commodity Futures Trading Commission Act of 1974 unless the Commission determines and notifies the Senate Committee on Agriculture and Forestry and the House Committee on Agriculture that it is unable to prescribe such terms and conditions within such period of time: Provided, That any such order, rule, or regulation may be made only after notice and opportunity for hearing: And provided further, That the Commission may set different terms and conditions for different markets.

33

In general, commodity options are presently offered to the public by persons whom I shall call commodity option dealers. These options involve many of the newly-regulated commodities, such as coffee, cocoa, sugar, gold, silver and copper. The following description of a commodity option transaction is based on the

...

Prior to the effective date of the CFTC Act the CE Act provided for the regulation of Wheat, cotton. rice, corn. oats. barley, rye flaxseed, grain, sorghums, mill feeds, butter. eggs. onions, Solanum tuberosum (Irish potatoes), wool, wool tops, fats and oils (including lard. tallow, cottonseed oil, peanut oil, soybean oil and other fats and oils). cottonseed meal. cottonseed, peanuts, soybeans, soybean meal, livestock, livestock products, and frozen concentrated orange juice.

The expanded definition of commodity includes, in addition to the specific commodities set forth in section 2(a)(1) of the CE Act. "all other goods and articles [except onions] . . . and all services. rights and interests in which contracts for future delivery are presently or in the future dealt in

33 By letters dated April 19, 1976, the CFTC notified the Chairmen of these Committees that the CFTC would require more time to adopt definitive regulations.

nature of options transactions in general, is not descriptive of the practices or policies of any particular firm or the components of any particular option contract, and is limited to a description of a "call" option on an actual commodity. A call commodity option on an actual commodity grants the customer the right to buy an actual commodity from the commodity option dealer at a particular price and during a specified period. Although the particulars vary, certain features of these options transactions are common at all such transactions. The expiration date of the option is the date after which the option may not be exercised. The "striking price" of the option is a set price at which the option customer may buy the underlying commodity upon exercising the option. If the striking price is below the then-prevailing market price for the underlying commodity, the option is profitable. This is known in the trade as an option which is "in the money". However, the market price may be below the striking price during the option exercise period. In that event, the option is unprofitable or "out of the money" in the trade vocabulary.

At stake in the market price fluctuations of the underlying commodity which determine the profitability of the option is the option purchaser's investment in the option the premium. The premium is the purchase price paid by the customer to the option dealer in order to obtain the option. The premium is not a standardized figure but is rather established by the dealer. Usually, dealers demand payment of the total option premium upon purchase of the option, although some dealers only require partial payment, in which case the customer may be subject to margin calls should the option go "out of the money." Also at stake is the customer's profit if the option is "in the money" during the time the option may be exercised.

To draw an analogy between an option transaction and a futures transaction, the payment by the customer of the premium is akin to the deposit by the customer of initial margin with a futures commission merchant. However, the amount of the premium is fixed, so that, if the entire premium is paid, there are no calls for maintenance margin. Should the customer pay only a part of the premium at the outset, however, there may be margin calls of up to the full amount of the premium; these margin calls can be analogized to calls for maintenance margin on a futures contract. However, unlike the situation prevailing in futures contract transactions, there are presently no segregation requirements imposed on commodity option dealers as there are on futures commission merchants to insure that customers owning in the money options will realize on their transactions or even recoup their premiums if the option dealer defaults. Moreover, since options are not presently traded on contract markets, there does not exist the clearing house mechanism to insure performance on commodity options.

Recent experience in the United States concerning the sale of commodity options dictates that the CFTC's regulations in this area incorporate adequate customer safeguards, the foundation of which would be segregation requirements similar to those imposed on futures commission merchants and clearing houses by section 4d (2) of the CE Act and the regulations thereunder. For example, the insolvency of one commodity option dealer resulted in a loss of 71 million dollars of customers' money. Due to the lack of regulation of this and similar companies, such as by the imposition of financial standards, segregation and other requirements, the only customer safeguard in such cases was the good faith and credit of the company involved. In many instances, customers who desired the proceeds of their transactions were paid with other customers' funds. Ultimately this pyramid collapsed.

34

The task confronting the CFTC is compounded by the diverse nature of commodity options transactions. Recently, for example, there have been increased sales in the United States of so-called "London" options. Generally these involve an option on (i.e., the right to acquire) a futures contract traded on a foreign commodities exchange. Such optio..s are often purchased by a U.S. commodity option dealer and carried in an omnibus account with a London broker. Generally the London broker considers only the U.S. dealer to be his customer and does not recognize the interests of the dealer's customers. The U.S. dealer then will purport to sell the option to his U.S. customer, although the dealer may in fact be the only person who recognizes any obligations to the customer. At the present time, neither U.S. nor London vendors of these options are required to segregate from their general assets the funds paid by or accruing to the benefit of U.S. customers. Nor do foreign clearing houses recognize and protect U.S. customers as do U.S. contract markets and their clearing houses. As a result,

34 H.R. Rep. No. 93-975, 93d Cong., 2d Sess. at 37 (1974).

should the U.S. commodity option dealer of a London option suffer bankruptcy, his U.S. customer may not be able to have his claims recognized by the trustee in bankruptcy, except perhaps through the application of traditional trust principles similar to those applied in the case of bankrupt futures commission merchants." Thus far I have spoken only of options on actual commodities or on foreign futures contracts. However, there is a totally new option concept which has been presented to the CFTC for approval. This is the trading of options on futures contracts traded on contract markets designated by the CFTC. Two contract markets have proposals before the CFTC respecting such options. Both call for the margining of the premium to be paid by customers and the clearance of trades much along the lines of the margining and clearance of trades of futures contracts themselves which I have already discussed. Should these or other proposals to trade options on futures contracts be approved, it is likely that such approval will be conditioned on compliance with segregation requirements to be developed by CFTC, similar to those provided in section 4d (2) and the regulations thereunder. Thus, virtually all of the concerns which I have already enumerated concerning the bankruptcy of futures commission merchants and of clearinghouses will apply to this form of option trading, should the CFTC permit its implementation.

As previously stated, Congress has granted extensive power to the CFTC in section 4c (b) of the CE Act. The CFTC can prohibit all forms of option trading or prohibit some forms and permit others, under such terms and conditions as it prescribes. In order to gain sufficient data upon which to base its determinations, on October 30, 1975, the CFTC assigned to its Advisory Committee on Definition and Regulation of Market Instruments the responsibility to study the offer and sale of commodity options and to submit recommendations on appropriate standards, restrictions or prohibitions in connection therewith. 40 Fed. Reg. 50557.

The report of the Advisory Committee on this subject has just been completed. One of the customer safeguards which the Advisory Committee has recommended to the CFTC is that the CFTC should require that dealers of commodity options, both on and off contract markets, segregate from their general assets: (a) all money and other property received from customers, including payments for the premium on the option, but excluding commissions, and (b) any profits in whatever form, i.e., cash, cash equivalents or physical commodities, due customers on options which are in the money." The Advisory Committee has indicated that it believes that any segregation program rests on the premise that the assets and profits to be segregated should be treated as the property of the customer, essentially in the same manner as futures contract "margin" funds of customers are treated under section 4d (2) of the CE Act. The CFTC is in the process of evaluating the Advisory Committee's recommendations. Whether and to what extent the CFTC will endorse those recommendations I, of course, cannot predict at this time. But, as I have already indicated, the CFTC regards its segregation requirements as fundamental to the protections to be afforded commodity customers and therefore particularly welcomes the views of the Advisory Committee on this point.

Assuming the CFTC permits a particular form of option trading, precisely how the CFTC will impose segregation requirements in the transaction is an extremely complex question which depends on such matters as whether the option involved is traded on or off a contract market, whether a foreign commodities exchange is involved, and whether there is margining of the premium. Subsumed in these matters are such issues as who is the party in the transaction who should be required to segregate and what assets should be segregated-i.e., all or part of the premium, profits accruing to the customer, the option contract itself and/or any assets obtained by the dealer to secure performance of the option. The resolution of these issues may not be the same for all forms of option trading which the CFTC may permit, and may be modified by the CFTC as it gains further insight into the trading of commodity options.

35 The CFTC was recently constrained to urge this result in a case involving a bankrupt U.S. dealer of London options. See In The Matter of J.S. Love & Associates Options, Ltd., Bankrupt (United States Court, Southern District of New York, Bankruptcy No. 76B590).

30 On October 22, 1975, the CFTC announced that it was considering various alternative methods to regulate options. 40 Fed. Reg. 49360. On February 20, 1976, the Commission published proposed rules concerning options trading off contract markets. 41 Fed. Reg. 7774. At the time of that proposal, the CFTC invited interested persons to participate in the rulemaking process by providing comments to the CFTC. Those rules did not contain a segregation requirment, but the CFTC invited comments on whether such a requirement should be imposed.

Nevertheless, Mr. Chairman, the concerns which I have already expressed concerning the need for amendment to the Bankruptcy Act to recognize CFTC segregation requirements in futures transactions apply as well to any segregation requirements which the CFTC may determine are appropriate to any particular form of commodity option trading.

I have already stated the CFTC's concerns that prevailing legal theories which trustees in bankruptcy have used are not adequate for the commodity futures industry and that specific statutory guidelines in the Bankruptcy Act are needed. The CFTC has the same concerns with respect to the bankruptcy of commodity option dealers, particularly with respect to any options which may ultimately be traded on contract markets. In addition, there is a further concern in the area of commodity options. Since there is no statutory requirement in the CE Act like that contained in section 4d (2) concerning segregation as to futures contracts, the CFTC is concerned that trustees in bankruptcy may be less inclined to apply even general trust law principles and/or tracing where segregation is required solely by CFTC regulations. Thus the CFTC believes it imperative that the Bankruptcy Act be amended to recognize the CFTC's segregation requirements which may be imposed by regulations pursuant to the CFTC's powers contained in section 4c (b) of the CE Act.

CFTC RECOMMENDATIONS

Based on the foregoing, the CFTC recommends that the Congress amend the Bankruptcy Act to provide as follows:

Where the bankrupt is any person who, in accordance with regulations adopted by the CFTC, is required to segregate from its assets, any money, securities or other property received from his customers in any transactions subject to regulation under section 4c (b) of the CE Act, or any profits or contractual or other rights in whatever form accruing to such customers in such transactions:

1. To the extent provided in such regulations, such money, securities and other property and such profits and contractual and other rights, shall constitute a single and separate fund. Such customers shall constitute a single and separate class of creditors entitled to share ratably in such fund on the basis of their net equities as of the date of bankruptcy.

2. The CFTC shall have the power, by rule, regulation or order, to specify how the net equities of any customer shall be determined, the method by which the business of the bankrupt shall be conducted after the date of bankruptcy and the manner in which property may be specifically identified as belonging to a particular customer and returned to such customer in accordance with a ratable distribution.

3. If any such transaction was executed on a contract market designated by the CFTC, no transfer or liquidation prior to or within five days of the date of bankruptcy of an open contractual commitment entered into by the bankrupt, and no payment or release of funds prior to the date of bankruptcy by the bankrupt, shall be set aside as a voidable preference, a fraudulent conveyance, or otherwise under either state or federal law; Provided such transfer, liquidation, payment or release was made in accordance with the rules of such contract market which have been approved by the CFTC or has otherwise been approved by the CFTC.

4. The CFTC shall receive prompt notice of the filing of the petition in bankruptcy and shall receive copies of any filings in the bankruptcy proceeding. On its application, the CFTC shall be admitted as a party, to the extent it deems appropriate, in the bankruptcy proceeding.

LEVERAGE TRANSACTIONS

Under Section 2(a)(1) of the CE Act, as amended, 7 U.S.C. 2, the CFTC is granted exclusive jurisdiction to regulate gold and silver leverage transactions subject to regulation under section 217 of the CFTC Act. Section 217 provides that: (a) No person shall offer to enter into, enter into, or confirm the execution of any transaction for the delivery of silver bullion, gold bullion, or bulk silver coins or bulk gold coins, pursuant to a standardized contract commonly known to the trade as a margin account, margin contract, leverage account, or leverage contract contrary to any rule, regulation or order of the Commodity Futures Trading Commission designed to insure the financial solvency of the transaction or prevent manipulation or fraud: Provided, That such rule, regulation, or order may be made only after notice and opportunity for hearing. If the Commission determines that any such transaction is a contract for future delivery within the meaning of the Commodity Exchange Act, as amended, such transaction shall be regulated in accordance with the provisions of such Act.

The following description of a leverage transaction subject to section 217 is based on the nature of leverage transactions in general, and is not descriptive of the practices or policies of any particular firm or the components of any particular contract. A "leverage transaction," as it is known in the trade, involves a contract to purchase gold or silver bullion or bulk gold or silver coins pursuant to a standardization agreement prepared by a seller which I shall call a leverage transaction merchant (hereinafter referred to as "LTM"). Under the contract, the customer pays a portion of the purchase price at the outset, and agrees to buy, and the LTM agrees to deliver, a specified amount of the particular commodity at a given price, at a specified time in the future. The purchase price for the commodity is determined by the LTM in its discretion. The amount of the initial payment required varies among LTM firms. The term of the contract also varies, but may be as long as 10 years. There may be prior delivery on demand by the customer upon satisfaction of the balance due on the contract.

In addition to the initial payment toward the commodity, a customer must also pay at the outset a sales commission which is a percentage of the total purchase price. Usually, there is also imposed a "maintenance," "interest" or "finance" charge on the unpaid balance which is required to be paid over the term of the contract. This charge ostensibly represents the interest element of the LTM's cost incurred by "covering" its obligation to deliver a commodity under the contract through the purchase of the physical commodity or a related futures contract. Coverage in physical commodities generally constitutes a small portion of whatever cover the LTM effects. There also may be imposed on customers a separate storage or service fee, which ostensibly represents the storage element of the LTM's cost incurred by covering in physical commodities or futures contracts. Other charges imposed on customers include applicable taxes and, in case of delivery, a freight or similar charge.

To the extent that LTMs cover in the futures market, they are subject to margin calls if the value of the futures contract falls. LTMs often meet these margin requirements by making, in turn, a margin call upon the purchaser of the leverage contract. Currently, practice varies among LTM firms as to whether, and the extent to which, funds paid by their customers toward the purchase price of the commodity are segregated from the general assets of the LTM. The same is true with respect to the property obtained by using such funds, such as physical commodities and futures contracts.

While there is limited experience as to the frequency of delivery in leverage transactions, available data indicate that delivery occurs in only a small percentage of transactions. Rather, most contracts are liquidated prior to maturity either through the failure of a customer to make required payments or through the LTM's repurchase of the customer's interest. [In some cases, liquidation is effected by the customer selling his interest to a third party.] Typically, LTMs are not obligated to repurchase, but often accommodate their customers.

Upon liquidation due to a customer's default, the customer remains liable to the LTM for any amounts then owing under the contract. In the event the commodity in the customer's account for which he had paid has risen in value, an appropriate credit is made against such amounts.

In the event a contract is liquidated through the LTM's repurchase of the customer's interest, the customer would receive his "equity," less any amount then owing to the LTM and any applicable repurchase commission. The customer's equity will either be equal to, or more or less than, the amount paid by him toward the purchase of the commodity, depending upon the LTM's thenprevailing repurchase price for the particular commodity involved.

The Congressional mandate to the CFTC in the area of leverage transactions is clear: to assure, to the extent possible, that such transactions are regulated so as to prevent fraud or manipulation and to preserve the financial solvency of the transaction. In the case of futures contract transactions. I have already explained how the CFTC's segregation requirements play an important role in achieving these objectives. How segregation requirements might be employed in the area of leverage transactions was one of the considerations which promoted the CFTC, on October 30, 1975, to assign to its Advisory Committee on Definition and Regulation of Market Instruments the responsibility to study the offer and sale of leverage transactions and to submit recommendations on appropriate standards, restrictions or prohibitions in connection therewith. 40 Fed. Reg. 50557.

The report of the Advisory Committee on leverage transactions has just been completed. One of the customer safeguards which the Advisory Committee has recommended is that the CFTC should require that LTMs segregate from their