Persons Engaging in Security Futures Product Transactions (Order Granting Temporary Exemption)

SECURITIES AND EXCHANGE COMMISSION

(Release No. 34-44729)

Order Granting Temporary Exemption to Certain Persons Engaging in Security Futures Product Transactions

August 21, 2001

The Commodity Futures Modernization Act of 20001 ("CFMA"), which became law on December 21, 2000, lifted the ban on single stock and narrow-based stock index futures ("security futures").2 In addition, the CFMA established a framework for joint authority over these newly-permissible products by the Securities and Exchange Commission ("SEC") and the Commodity Futures Trading Commission ("CFTC"). Section 6(g)(5) of the Securities Exchange Act of 19343 ("Exchange Act") makes it unlawful for any person to execute or trade a security futures product until the later of: (1) December 21, 2001 (one year after the enactment of the CFMA); or (2) the date a futures association registered under Section 17 of the Commodity Exchange Act4 ("CEA") has met the requirements set forth in Section 15A(k)(2) of the Exchange Act.5 Nevertheless, Section 6(g)(5) of the Exchange Act permits a person to execute or trade a security futures product if: (1) the transaction is entered into on a principal-to-principal basis between parties trading for their own accounts or as described in Section 1(a)(12)(B)(ii) of the CEA; (2) the transaction is entered into between eligible contract participants (as defined in Section 1(a)(12)(A), (B)(ii), and (C) of the CEA) at the time at which the persons enter into the agreement, contract, or transaction; and (3) the transaction is entered into on or after the later of (a) August 21, 2001 (8 months after the date of enactment of the CFMA); or (b) the date that a futures association registered under Section 17 of the CEA has met the requirements set forth in Section 15A(k)(2) of the Exchange Act.6

The National Futures Association ("NFA") is currently the only registered futures association under Section 17 of the CEA.7 The NFA is also a registered national securities association for the limited purpose of regulating the activities of its members registered under Section 15(b)(11) of the Exchange Act8 as brokers or dealers in security futures products.9 Among other things, such a securities association shall have rules that:

are designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, and, in general, to protect investors and the public interest, including rules governing sales practices and the advertising of security futures products reasonably comparable to those of other national securities associations registered pursuant to [Section 15A(a) of the Exchange Act] that are applicable to security futures products.10

Because the National Association of Securities Dealers, Inc. ("NASD") is currently the only national securities association registered with the SEC pursuant to Section 15A(a),11 the NFA must have rules reasonably comparable to the NASD's rules.

The NASD has established a body of rules governing the conduct of its members. Among the NASD rules applicable to security futures products are Rule 2320 ("Best Execution and Interpositioning") and Rule 2440 ("Fair Prices and Commissions"). NASD Rule 2320 generally requires NASD members, in any transaction with or for a customer, to use reasonable diligence to ascertain the best inter-dealer market for a security, and to buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions. NASD Rule 2440 generally requires NASD members, in any "over-the-counter" transaction with or for a customer, to charge only fair commissions or charges, and to buy or sell securities only at fair prices. Although the rule is limited to "over-the-counter" transactions, NASD has taken the position that excessive commissions for transactions in exchange-listed securities may violate its rules requiring members to observe high standards of commercial honor and just and equitable principles of trade.12

The NFA has filed with the CFTC and SEC a range of new rules and amendments to its current rules designed to satisfy the "reasonably comparable rule" requirement of Section 15A(k)(2) and other obligations it has under Section 15A(k) of the Exchange Act. At this time, however, the NFA has not filed rules reasonably comparable to those of the NASD described above. In addition, the NFA has not yet filed rules that ensure that members and natural persons associated with members meet such standards of training, experience and competence as necessary to effect transactions in security futures products and are tested for their knowledge of securities and security futures products.13 Because Section 15A(k)(2)(D) of the Exchange Act requires the NFA to have such rules, the NFA does not presently meet the requirements of that section.14 As a consequence, one condition in Section 6(g)(5) to allow persons to execute or trade a security futures product is not satisfied.

Nevertheless, the Commission believes that it would be appropriate in the public interest and consistent with the protection of investors to exempt temporarily, subject to certain conditions, persons from the prohibition in Section 6(g)(5) on executing or trading security futures products. In particular, although the NFA does not yet have rules reasonably comparable to the NASD's rules on best execution and interpositioning or fair prices and commissions, the exemption will be applicable only when persons are trading on a principal-to-principal basis without the intermediation of a broker or dealer. The NFA's current lack of rules regarding standards of training, experience and competence for professionals with respect to security futures products is less critical when persons trade on a principal-to-principal basis without a broker or dealer acting as an intermediary. Balancing Congressional intent that sophisticated persons be able to begin trading security futures as soon as possible after August 21, 2001, against the need for the full protections contemplated in the regulatory system for this class of persons, the Commission believes that this exemption is appropriate when the transaction is both entered into: (1) on a principal-to-principal basis between parties trading for their own account or as described in section 1a(12)(B)(ii) of the CEA; and (2) between eligible contract participants (as defined in Section 1(a)(12)(A), (B)(ii), and (C) of the CEA) at the time at which the persons enter into the agreement, contract, or transaction.

Accordingly,

IT IS ORDERED, pursuant to Section 36 of the Exchange Act,15 that, until December 21, 2001, any person engaging in any security futures product transaction that meets the conditions set forth in paragraph (B)(i) of Section 6(g)(5) of the Exchange Act is exempt from the prohibition on executing or trading security futures products under Section 6(g)(5) of the Exchange Act.16

By the Commission.17

Jonathan G. Katz
Secretary

Footnotes
1 P.L. 106-554, 114 Stat. 2763 (2000).

2 The CFMA also provided for the trading on a delayed basis of options on security futures. Security futures and options on them are defined as "security futures products." Exchange Act Section 3(a)(56); 15 U.S.C. 78c(a)(56).

3 15 U.S.C. 78f(g)(5).

4 7 U.S.C. 21.

5 15 U.S.C. 78o-3(k)(2).

6 Exchange Act Section 6(g)(5)(B); 15 U.S.C. 78f(g)(5).

7 7 U.S.C. 21.

8 15 U.S.C. 78o(b)(11).

9 Exchange Act Section 15A(k)(1); 15 U.S.C. 78o-3(k)(1).

10 Exchange Act Section 15A(k)(2)(B)(i); 15 U.S.C. 78o-3(k)(2)(B)(i).

11 15 U.S.C. 78o-3(a).

12 See Atlanta-One, Inc. v. Securities and Exchange Commission, 100 F.3d 105, 107 n. 1 (9th Cir. 1996) denying pet. for review, In the Matter of Atlanta-One, Inc., Securities Exchange Act Release No. 35455, 52 S.E.C. 161, 1995 SEC Lexis 593 (March 8, 1995).

13 Exchange Act Section 15A(k)(2)(D); 15 U.S.C. 78o-3(k)(2)(D). In addition, the Commission notes that the NASD, NFA and other self-regulatory organizations are currently drafting a disclosure statement that their respective rules will require members to deliver to customers who effect transactions in security futures products. At the time the NASD adopts a rule requiring its members to deliver this disclosure document, Section 15A(k)(2)(B)(i) of the Exchange Act [15 U.S.C. 780-3(k)(2)(B)(i)] would require the NFA to adopt a reasonably comparable rule.

14 15 U.S.C. 78o-3(k)(2).

15 Section 36 of the Exchange Act [15 U.S.C. 78mm] authorizes the Commission to conditionally or unconditionally exempt any person, security, or transaction, or any class thereof, from any provision of the Exchange Act or rule thereunder, if necessary or appropriate in the public interest and consistent with the protection of investors.

16 15 U.S.C. 78f(g)(5).

17 Chairman Pitt did not participate in this matter.