31.01.2012

By Jill Sommers

On 9 November 2011, the Commodities Futures and Trading Commission(CFTC) voted to make me the senior commissioner with respect to MF Global Matters. This authorises me to exercise the executive and
administrative functions of the Commission solely with respect to:

•The pending enforcement investigation;
•The pending bankruptcy case in the Southern District of NY involving MF Global (which is the broker-dealer/futures commission merchant);
•The pending bankruptcy case in the Southern District of NY involving MF Global Holdings (which is the parent company); and
•Other actions to locate or recover customer funds or determine the reasons for shortfalls in the customer accounts.

Pending Bankruptcy Cases

As I understand the Securities Investors Protection Act of 1970 (SIPA), the SEC has the authority to refer an entity registered as a broker-dealer (whether or not such entity is also registered as an Futures Commissions Merchant (FCM)) to the Securities Investors Protection Corporation (SIPC) if there is reason to believe that the entity is in or is approaching financial difficulty. SIPC may initiate a liquidation proceeding to protect customers of an insolvent broker-dealer when certain statutory criteria are met. In this instance, the liquidation was initiated on 31 October, with the support of the CFTC and consent of MF Global. When a broker-dealer is also a registered FCM, as MF Global was, there is one dually-registered entity and the entire entity gets placed into liquidation. Because there is one entity, it is not possible to initiate a SIPA liquidation of the broker-dealer, and a separate bankruptcy proceeding for the FCM. It is important to note, however, that when a dually-registered BD/FCM is placed into a SIPA liquidation proceeding, the relevant provisions and protections of the Bankruptcy Code, the Commodity Exchange Act (CEA), and the commission’s regulations apply to commodity accounts just as they would if the entity were solely an FCM and in a non-SIPA bankruptcy proceeding.

An obvious point to make is that if a firm is involved in a bankruptcy
proceeding, something must have gone very wrong. Bankruptcy proceedings can be very complicated and at times, messy. This can be magnified when the bankruptcy is among the largest in history and there are serious questions about the location of customer funds. The
commission is no stranger to FCM bankruptcies. Lehman Brothers and Refco are the two most recent FCM bankruptcies. While the Lehman
Brothers bankruptcy was monumental in scale, and the Refco bankruptcy involved serious fraud at the parent company, commodity customers did not lose their money at either firm. In both instances, commodity customer accounts were wholly intact, that is, they contained all open positions and all associated segregated collateral. That being the case, customer accounts were promptly transferred to healthy FCMs, with the commodity customers having no further involvement in the bankruptcy proceeding.

Unfortunately that is not what happened at MF Global because customer accounts were not intact.

In FCM bankruptcies, commodity customers have an exclusive right to customer property. This includes, without limitation, segregated property, property that was illegally removed from segregation and is still within the debtor’s estate, and property that was illegally removed from segregation and is no longer within in the debtor’s estate, but is clawed-back into the debtor’s estate by the trustee. If the customer property as I just described is insufficient to satisfy in full all the claims of customers, Part 190 of the commission’s regulations allow other property of the debtor’s estate to be classified as customer property to make up any shortfall. A parent or
affiliated entity, however, generally would not be a debtor unless customer funds could be traced to that entity.

Within the first weeks of the MF Global bankruptcy, the trustee for the BD/FCM had, with the encouragement and assistance of the CFTC, transferred nearly all positions of customers trading on US commodity futures markets, and transferred approximately $2 billion (£1.3 billion) of customer property. On 29 November, the trustee moved to transfer an additional $2.1 billion back to customers, to be used to “top up” all
commodity customers to at least two-thirds of their account values as reflected on the books and records of MF Global. The commission fully
supported the trustee’s motion. Last Friday, the Bankruptcy Court granted the motion, and it appears that the top-up amount will be closer to 72 per cent. The additional $2.1 billion transfer is expected to be completed within two to four weeks. The transfers to date demonstrate that commodity customers are receiving the highest priority in claims to the bankruptcy estate. Nonetheless, we understand that more must be done.

FCM Investment of Customer Funds

An FCM is authorised to invest funds that are in customer segregated accounts. This authorisation is found in Section 4d of the CEA and in Commission Regulation 1.25. Regulation 1.25 only relates to how an FCM can invest customer funds. Moreover, any losses that may occur as a result of those permissible investments are the responsibility of the FCM, not the customer. Prior to December 2011, Regulation 1.25 allowed an FCM to invest customer funds in highly-rated foreign sovereign debt, but the investment was strictly limited to the amount of that nation’s foreign currency a customer posted to the FCM. Regulation 1.25 does not, and has never, had anything to do with investments that an SEC/FINRA-regulated BD makes for its own account.

In thinking about the investment of customer funds, it may be helpful to draw an analogy to a savings account at a bank. Let’s say someone opens a savings account with $1,000 and the bank agrees to pay 0.25 per cent interest annually. That $1,000 is not just sitting at the bank waiting for the depositor to come and get it. The bank invests that money, or loans it to others, etc, with the goal of earning a rate of return greater than the 0.25 per cent interest the bank is obligated to pay the depositor. Very simply stated, if the bank earns a rate of return greater than 0.25 per cent, that is net revenue for the bank. If the bank earns a rate of return less than 0.25 per cent, there is a net loss.

Broadly speaking, the investment of customer funds by an FCM is similar, but there are critical safeguards and restrictions placed on FCMs. Section 4d of the CEA and Commission Regulation 1.25 list the only permissible investments an FCM can make with customer funds. The CFTC has been, and continues to be, mindful that customer segregated funds must be invested in a manner that minimises their exposure to credit, liquidity, and market risks both to preserve their availability to customers and DCOs and to enable investments to be quickly converted to cash at a predictable value. As such, Regulation 1.25 establishes a general prudential standard by requiring that all permitted investments be “consistent with the objectives of preserving principal and maintaining liquidity”.

While an FCM is permitted to invest customer funds, it is important to note that if an FCM does so, the value of the customer segregated account must remain intact at all times. In other words, when an FCM invests customer funds, that actual investment, or collateral equal in value to the investment, must remain in the customer segregated account at all times. If customer funds are transferred out of the segregated account to be invested by the FCM, the FCM must make a simultaneous transfer of assets into the segregated account. An FCM cannot take money out of a segregated account, invest it, and then return the money to the segregated account at some later time.

Customer Accounts at FCMs

When a customer opens a trading account at an FCM, CFTC regulations require the customer to be provided with a risk disclosure statement that generally centers on market risk, market volatility, and leverage. Pursuant to Commission Regulation 1.55(b)(6), the required risk disclosure statement must also include the following: “You should consult your broker concerning the nature of the protections available to safeguard funds or property deposited for your account.” There are no required disclosures
concerning how customer funds can be invested by an FCM.
Commission Regulation 1.20 requires that accounts holding segregated funds be titled specifically to identify the contents of the account as separate from the ownership of the FCM.

In addition, FCMs must obtain letters from their depositories acknowledging that the depositories cannot exercise any rights of offset to such accounts for obligations of the FCM.Commission Regulation 1.12 requires FCMs to notify the Commission immediately of an occurrence of under-segregation. FCMs also must notify the CFTC of instances of significant margin calls (such as a margin call to a customer, which if not made, would put fellow customers at risk if an adequate buffer or “excess segregation” was not in
segregated accounts).

A customer is required to post margin to support futures positions.

Generally, a customer deposits more than the minimum initial margin required for the positions established. The additional funds provide a buffer so a customer can place trades without posting additional margin, and lessen the likelihood of repeated margin calls or having positions liquidated if margin calls are not met on a timely basis. In addition to customers depositing additional margin, in practice, FCMs typically maintain
significant amounts of their own capital as “excess segregated funds.” By doing this, one customer’s deficit due to market moves or unmet margin calls is covered by the FCM’s buffer and does not result in one customer’s funds being exposed to the credit risk of another customer. FCMs are not obligated to provide excess segregated funds, but given the legal obligation at all times to have sufficient funds in segregated accounts to cover all liabilities to customers, FCMs generally find it wise to have a buffer.

A customer may withdraw excess margin funds or use such funds as the customer deems appropriate. This would include using the funds for non-futures related transactions with the FCM. If the excess funds held by the FCM are used in a manner directed by the customer such that the funds are not maintained in a futures segregated account, the funds would not have the protections afforded segregated customer funds under the Bankruptcy Code and Part 190 of the commission’s regulations.

Oversight of FCMs

FCMs are subject to CFTC-approved minimum financial and reporting requirements that are enforced in the first instance by a designated self-regulatory organisation (DSRO), for example, the Chicago Mercantile Exchange or the National Futures Association. DSROs also conduct periodic compliance examinations on a risk-based cycle every 9 to 15 months. The requirements of DSRO examinations are contained in Financial and Segregation Interpretations 4-1 and 4-2, which are specified as application guidance to Core Principle 11 (Financial Integrity) for Designated Contract Markets. The Commission has proposed codifying the essential components of these interpretations into an amended Commission Regulation 1.52.

An examination of segregation compliance is mandatory in each examination (certain other components need not be included in every examination). This examination includes a review of the depository acknowledgement letters and the account titles of segregated
accounts (unless unchanged from the prior examination); verifying account balances, and ensuring that investment of customer funds is done in accordance with Commission Regulation 1.25.

Commission Regulation 1.10 requires FCMs to file monthly unaudited financial reports with the CFTC and the DSRO. These reports include the FCM’s segregation and net capital schedules, and any “further material information as may be necessary to make the required statements and schedules not misleading”. Each financial report must be filed with an oath or attestation, and for a corporation, the oath must be by the CEO or CFO.

Commission Regulation 1.16 requires FCMs to file annual certified financial reports with the CFTC and the DSRO. The audits require, among other things, that if a new auditor is hired, that new auditor is required to notify the CFTC of certain disagreements with statements made
in reports prepared by prior auditors. Auditors also must test internal controls to identify, and report to the CFTC, any “material inadequacy” that could reasonably be expected to: inhibit a registrant from completing transactions or promptly discharging responsibilities to customers or other creditors; result in material financial loss; result in material misstatement of financial statements or schedules; or result in violation of the CFTC’s segregation, secured amount, recordkeeping or financial reporting requirements.

Conclusion

While our current focus is returning as much money as possible to customers, we are expending an enormous amount of effort to locate the missing customer funds and pursuing the enforcement investigation. All of the information we learn during these aspects of our work will be relevant to the CFTC as it considers “lessons learned” and any policy responses or regulatory changes. It is just too early to tell, however, what responses and/or changes the CFTC will find appropriate.

Obviously, the CFTC has a great deal of work ahead of it to get customer funds back where they need to be, to determine what went wrong with segregated funds at MF Global, to determine whether to prosecute any violations of the Act, and to determine what needs to be done to prevent a similar circumstance in the future. CFTC staff is coordinating on these issues with sister regulators both domestically and overseas, and is working closely with the SIPA Trustee to provide whatever support he needs to resolve issues with commodity customer accounts.

This is an edited version of evidence given to the US Senate Agricultural Committee on 12 December 2011.