U.S. Regulators Adopt Rules Regarding Futures Contracts on Debt Indexes and Securities

Executive Summary

On July 13, 2006, the Commodity Futures Trading Commission ("CFTC") and the Securities and Exchange Commission ("SEC") adopted joint final rules and rule amendments (collectively, the "Final Rules") relating to the regulation of futures contracts on debt securities indexes ("Debt Index Futures") and futures contracts on individual, non-governmental debt securities ("Debt Security Futures"). The Effective Date of the Final Rules will be August 14, 2006. As described in the related Adopting Release¹, the Final Rules have two purposes:

• To set forth criteria for Debt Index Futures which, if satisfied, would allow such qualifying contracts to trade subject to the exclusive jurisdiction of the CFTC; and

• To expand the statutory listing standards requirements to permit the trading of Debt Security Futures, as well as Debt Index Futures on narrowbased security indexes.

The adoption of these rules will likely result in the creation of new types of exchange-traded derivative contracts, since the laws governing the regulation of security futures contracts did not previously permit the trading of either Debt Index Futures or Debt Security Futures. The purpose of this article is to provide financial service industry professionals with a brief overview of this regulatory structure and a summary of the Final Rules.

The Regulation of Security Futures and a Summary of the Final Rules

Under the securities and commodities laws of the United States, the CFTC has exclusive jurisdiction over (1) futures contracts on an index that does not constitute a "narrow-based security index" and (2) futures contracts on exempted securities (i.e., U.S. Treasury securities). By comparison, these laws require the CFTC and the SEC to jointly regulate futures contracts on "narrow-based security indexes" and individual securities that are not exempted securities (collectively, "security futures").² Historically, the laws that govern the regulation of security futures have prevented the development of a market for either Debt Index Futures or Debt Security Futures. As explained in the Adopting Release, the key rationale behind the adoption of the Final Rules is to facilitate the development of a market for these types of futures contracts.

The Commodities Exchange Act ("CEA") and the Securities Exchange Act of 1934 (the "Exchange Act") define a narrow-based security index as an index that meets any one of the following criteria:

• The security index is comprised of nine or fewer component securities;

• Any single component security comprises more than 30 percent of the index’s weighting;

• Any group of five component securities comprises more than 60 percent of the index’s weighting;

• The lowest weighted component securities comprising, in the aggregate, 25% of the index’s weighting have an aggregate dollar value of average daily trading volume ("ADTV") of less than $50 million.³

This statutory definition was designed for equity securities indexes, but when applied to a debt securities index the definition will almost always result in the treatment of that index as a narrow-based security index. This result is primarily due to the fact that debt securities do not trade as frequently as equity securities and, therefore, can not satisfy the $50 million ADTV requirement. As explained by the SEC and the CFTC in the Adopting Release, "[B]ecause few debt securities meet the ADTV criterion in the statutory definition of narrowbased security index, most indexes comprised of debt securities, regardless of the number or amount of underlying component securities in the index, would fall within the statutory definition of a narrow-based security index."

In order to take characteristics relevant to debt securities into consideration, the SEC and CFTC have adopted Rule 41.15 under the CEA and Rule 3a55-4 under the Exchange Act. These two rules establish a set of four separate criteria that must be satisfied in order for a debt securities index to qualify for exclusion from the definition of a narrow-based securities index. Debt Index Futures contracts on such a qualifying index will trade subject to the exclusive jurisdiction of the CFTC.

(1) The Index Must Be Composed of Debt Securities.
Each component security of the index must be a "debt security," which is defined as a note, bond, debenture, or other evidence of indebtedness.⁴ Additionally, the component securities cannot be equity securities or securities that are convertible into equity securities.⁵

(2) Number and Weighting of Component Securities.
The index must meet diversification requirements with respect to both issuers and the component securities. Specifically, the Final Rules require that:

• The index must be comprised of ten or more securities issued by ten or more non-affiliated issuers;

• The securities of any issuer cannot comprise more than 30 percent of the index’s weighting; and

• The securities of any five non-affiliated issuers cannot comprise more than 60 percent of the index’s weighting.⁶

For purposes of the exclusion from treatment as a narrow-based securities index, the term "issuer" includes a single issuer of a component security, as well as a group of "affiliated" issuers. Additionally, for purposes of the Final Rules, an issuer is "affiliated" with another issuer if it controls, is controlled by, or is under common control with that other issuer (with "control" being defined to mean ownership of 20 percent or more of an issuer’s equity or the ability to direct the voting of 20 percent or more of an issuer’s voting equity). As explained in the Adopting Release, "these criteria…reduce the likelihood that a future on…a debt securities index would be overly dependent on the price behavior of a component single security, small group of securities or issuers, or group of securities issued by affiliated parties."

(3) Issuer Eligibility.
Subject to the limited exception of U.S. government securities and foreign sovereign debt obligations, the issuers of the component securities must satisfy one of the following criteria:

• The issuer must file reports pursuant to Sections 13 or 15(d) of the Exchange Act;

• The worldwide market value of the outstanding equity of the issuer (excluding equity held by affiliates of such issuer) must exceed $700 million; or

• The value of all outstanding notes, bonds, debentures or evidence of indebtedness of the issuer must have a total remaining principal amount of at least $1 billion.

The Final Rules establish these issuer eligibility criteria to help ensure that that there is a sufficient amount of publicly available information regarding the issuer of a component security and to make it less likely that an index would be subject to manipulation.

(4) Minimum Remaining Principal Amount.
Under the Final Rules, each component security (with the exception of certain municipal securities, as explained in the next paragraph) would be required to have a total remaining principal amount of at least $250 million. This criterion was adopted in lieu of a trading volume requirement, due to the limited trading activity in debt markets.⁷

In response to comments from The Board of Trade of the City of Chicago, the SEC and CFTC adopted an exemption from the minimum remaining principal requirement for municipal securities. Specifically, the Final Rules provide that a municipal security may be included in an otherwise qualifying index if it satisfies the following criteria:

• The security meets the $250 million minimum remaining principal requirement discussed above; or

• The security has a remaining principal amount outstanding of $200 million; and

• The issuer of the security has outstanding securities that are notes, bonds, debentures or evidences of indebtedness that have a total remaining principal amount of at least $1 billion.

The Final Rules contain a de minimis exception that would allow a debt security index to qualify for the exclusion from the definition of a narrow-based security index, even if the requirements regarding issuer eligibility and the minimum remaining principal criteria are not satisfied. Specifically, these two criteria would not apply in circumstances where the following two conditions are satisfied:

• All securities of an issuer included in the index that do not satisfy the issuer eligibility and minimum remaining principal balance criteria represent less than 5 percent of the index’s weighting; and

• Securities comprising at least 80 percent of the index’s weighting satisfy the issuer eligibility and minimum remaining principal balance criteria (based on the entire index’s weighting inclusive of issuers that are not required to satisfy the issuer eligibility and minimum remaining principal balance requirements).

The SEC and CFTC have clarified that the Final Rules permit (but do not require) an index’s exempted securities (other than municipal securities) to be excluded from the index in determining whether the index meets the requirements of the new rules. As explained in the Adopting Release, the SEC and the CFTC believe that this "de minimis exception provides some flexibility in constructing an index or determining whether a debt securities index satisfies the exclusion."

The Final Rules also serve to modify the listing standards for security futures contracts, as set forth in the CEA and the Exchange Act.⁸ The Exchange Act prohibits the trading of security futures that are not listed on a national securities exchange or a registered national securities association.⁹ Additionally, a national securities exchange is permitted to trade only those security futures products that meet listing standards filed by the exchange with the SEC and the requirements of the CEA.¹⁰ Prior to the adoption of the Final Rules, the Exchange Act and the CEA required a futures contract to be based on common stock or other equity securities.¹¹ As such, Debt Security Futures and Debt Index Futures that reference a narrow-based security index were not permitted to be traded under the Exchange Act and the CEA.

Pursuant to an amendment to Rule 41.21 under the CEA and the adoption of Rule 6h-2 under the Exchange Act, the CFTC and the SEC have modified the listing standards for security futures. Specifically, the Final Rules permit the trading of security contracts based on notes, bonds, debentures or other evidences of indebtedness (i.e., Debt Security Futures). In addition, the Final Rules allow for the trading of security futures based on narrow based security indexes (i.e., Debt Index Futures that are subject to joint jurisdiction of the SEC and the CFTC).

The adoption of the Final Rules represents two significant changes to the regulation of securities-based futures contracts:

• The Final Rules establish criteria for Debt Index Futures which, if satisfied, allow such qualifying contracts to trade subject to the exclusive jurisdiction of the CFTC; and

• The Final Rules expand the statutory listing standards requirements to permit the trading of Debt Security Futures, as well as Debt Index Futures on narrow-based security indexes.

These changes, in turn, are likely to result in the creation of new types of exchange-traded derivative contracts that, according to the SEC and the CFTC, will constitute "potentially useful financial products."

This article is presented for informational purposes only and is not intended to constitute legal advice.