United States: Financial Services Alert

The Commodity Futures Trading Commission (the "CFTC") proposed new rules (the "Proposed Rules") implementing the trading facility provisions of the Commodity Futures Modernization Act of 2000 (the "CFMA"). The CFMA, enacted in December, 2000, amends the Commodity Exchange Act (the "CEA") and is the most important regulatory development affecting financial derivatives activities since the CFTC promulgated 7 C.F.R. Part 35, the partial regulatory safe harbor for certain swap agreements (the "Swap Exemption"), in 1993. Prior to the CFMA, the CEA generally prohibited futures contracts unless entered into on a futures exchange subject to substantial CFTC regulation. At the same time, legal uncertainties created by the CEA and the Swap Exemption effectively barred the clearing of swaps and the execution of swaps on multilateral facilities such as electronic computer networks or alternative trading systems. Accordingly, derivatives activities before the CFMA were clearly divided into two different realms: (1) swaps, which are generally individually negotiated on a bilateral basis (usually over the telephone) and not regulated under the CEA; and (2) futures, which are generally bought and sold on floors of exchanges subject to extensive CFTC regulation. Among other things, the CFMA clarifies that swaps and other off-exchange derivatives are legal and generally outside the scope of the CEA, even if they are cleared or executed on multilateral trading facilities, provided certain conditions are met. At the same time, the CFMA replaces the previous "one-size-fits- all" scheme of regulation for financial futures with three tiers of more flexible CFTC supervision: (1) "exempt boards of trade"; (2) "derivatives transaction execution facilities" ("DTEFs"); and (3) "designated contract markets." Although generally regarded as deregulatory in nature, the CFMA blurs distinctions between swaps and futures and thereby raises various regulatory questions for institutions seeking to apply new business-to-business electronic trading technologies to swaps and other risk-shifting financial transactions without triggering CFTC regulatory jurisdiction.

Part 36 of the Proposed Rules sets forth CFTC notification and price dissemination procedures that apply to exempt boards of trade, the least regulated of the new tiers of trading facilities for futures. An exempt board of trade is excluded from most CEA provisions, but only if all parties to contracts executed thereon qualify under Section 1a(13) of the CEA, as amended by the CFMA, as "eligible contract participants" ("ECPs"), a category that includes certain categories of institutional, sophisticated, and wealthy participants. In addition, Section 36.2(a) of the Proposed Rules clarifies that, to qualify for execution on an exempt board of trade, a futures contract must be based on an "excluded commodity" as defined in Section 1a(12) of the CEA as amended by the CFMA (a definition that encompasses most financial instruments) and may not be not based on a security or securities index. Part 37 of the Proposed Rules governs DTEFs, the new intermediate tier of futures trading facility. Under the CFMA, DTEFs are open not only to ECPs, but also to non-ECPs, including retail participants, provided such non-ECPs act through futures commission merchants that meet certain new capitalization, clearing, and self-regulatory criteria. Part 38 of the Proposed Rules governs designated contract markets, setting forth a new regulatory framework for fully regulated futures exchanges. Both Parts 37 and 38 of the Proposed Rules specify new approval timelines and include detailed appendices on application procedures and compliance matters. Part 40 of the Proposed Rules applies to DTEFs, designated contract markets, and derivatives clearing organizations and sets forth certain new procedures for product listing, rule changes, and other matters.

In addition to the new rules on trading facilities, Proposed Rule 1.1 is a new anti-fraud provision that implements CFMA Section 102, which amends the CEA’s so-called "Treasury Amendment" to give the CFTC new authority over agreements, contracts, and transactions in foreign currencies between retail customers and counterparties other than financial institutions, broker-dealers, futures commission merchants, insurance companies, financial holding companies, investment bank holding companies, and affiliates thereof.

The CFTC announced that it will soon propose additional regulations addressing remaining aspects of the new CFMA framework relating to clearing and intermediaries. Comments on the Proposed Rules are due by April 9, 2001.

• OTS Issues Final Rule Easing Application Procedures And Reducing Pre-Filing Requirements

The OTS issued a final rule (2001-11, the "Final Rule") that makes it easier and less costly to file applications with the OTS and limits the circumstances in which a pre-filing conference with the OTS is required. The Final Rule explains, among other things: (1) how the OTS computes application timetables; (2) how the applicant can determine the appropriate OTS office in which to file an application; and (3) how the applicant can protect the confidentiality of information filed with the OTS. The major change from the proposed version of the Final Rule involves pre-filing. In the Final Rule, a pre-filing meeting with the OTS and the submission of a draft business plan is automatically required only in connection with a proposal to establish a new federal savings association ("FSA"). For certain conversion applications, commercial bank and credit union applicants are required to meet with the OTS before filing, but the OTS has the discretion to request the applicant to file a draft business plan. For change-of-control applications, the OTS will determine on a case-by-case basis whether it will require a pre-filing meeting or the submission of a draft business plan. Moreover, while the original proposal required that applicants requesting approval of "complex" transactions (including the establishment of de novo FSAs, conversions and change-of-control of FSAs) hold pre-filing meetings with the OTS at least 30 days in advance of filing, the Final Rule grants the applicable Regional Office of the OTS the discretion to set a schedule for pre-filing meetings, the submission of a draft business plan and the submission of such other information as the OTS Regional Office deems appropriate. The Final Rule is effective April 1, 2001 except that one section, involving a determination by the OTS that an application is deemed withdrawn because it has not been acted on within 2 years of the initial filing, will be effective on July 1, 2001.

• SEC Permits 4% Redemption Fee For Limited Period In Connection With Fund’s Conversion To Open-End Status

In a no-action letter (Fidelity Advisor Korea Fund, Inc. (publ. avail. March 7, 2001)), the SEC permitted a single country fund (the "Fund") converting from closed-end to open-end status (the "Conversion") to charge a 4% redemption fee for a limited time after the Conversion. Because the Fund generally traded at a significant discount to its net asset value, considerable arbitrage activity was expected in connection with the Conversion. Through imposition of a 4% redemption fee on shares participating in the Conversion, the Fund sought to discourage redemptions by arbitrageurs for the 199 day period immediately following the Conversion or, alternatively, to offset the adverse impact on the Fund of redemptions that took place during that timeframe. (The Conversion took place on June 30, 2000.)

To arrive at the amount of the redemption fee, the Fund’s adviser evaluated average trading costs incurred in connection with trading securities on the relevant markets for the preceding three years for all of its advisory accounts, including the fund complex of which the Fund is a part. Based on this information, the adviser concluded that a 4% redemption fee was reasonably related to the anticipated portfolio and administrative costs associated with the potentially large level of redemptions as well as the investment opportunity and market costs that could result from the forced liquidation of portfolio securities. In granting relief, the SEC relied on certain facts, such as that (1) redemption costs would be magnified due to the Fund’s concentration in assets in a single emerging market, (2) the Fund’s investment adviser and directors determined that (i) the redemption fee was necessary to discourage short-term trading and to protect the interests of non-redeeming shareholders and (ii) the amount of the redemption fee was reasonably related to the costs expected to be incurred, (3) the increased redemption fee was limited to a period that reflected the adviser’s estimate of the time during which arbitrage-related redemptions or exchanges were most likely to occur, and (4) Fund shareholders who would be subject to the redemption fee approved the Conversion after receiving a proxy statement that described the fee.