SEC Division of Trading and Markets no-action letter: National Futures Association

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March 22, 2004 [Revised - May 6, 2004]

Mr. Thomas W. Sexton Vice President and General Counsel National Futures Association 200 West Madison Street, Suite 1600 Chicago, IL 60606

Dear Mr. Sexton:

In your letter dated March 22, 2004, on behalf of the National Futures Association, you request assurance that the staff of the Division of Market Regulation would not recommend enforcement action to the Commission under Section 15(a) of the Securities Exchange Act of 1934 ("Exchange Act") if an NFA member that is registered as a futures commission merchant, and also notice-registered with the Commission as a broker-dealer ("NFA Member FCM"), originates and maintains a special omnibus account for the purpose of effectuating the process of making or taking delivery of physically settled security futures contracts on behalf of its customers on infrequent occasions without registering as a fully registered broker-dealer under Section 15(b) of the Exchange Act.

Based on the facts presented and the representations you have made, and without necessarily concurring in your analysis, the staff will not recommend enforcement action to the Commission under Section 15(a) of the Exchange Act if an NFA Member FCM engages in the activities described in your letter without registering as a fully registered broker-dealer under Section 15(b) of the Exchange Act. In taking this position, we note in particular the fifteen criteria set forth in your letter. We also note that the NFA, through its audit programs, will check to ensure that delivery is not occurring more often than would be expected considering the infrequency of delivery in the futures markets and the type of customer.

This position concerns enforcement action only and does not represent a legal conclusion with respect to the applicability of statutory or regulatory provisions of the federal securities laws. Moreover, this position is based on the facts you have presented and the representations you have made, and any different facts or conditions may require a different response. In addition, this position is subject to modification or revocation if at any time the Commission or the staff determines that such action is necessary or appropriate in furtherance of the purposes of the Exchange Act. Finally, the staff expresses no view with respect to any other questions that the proposed activities may raise, including the applicability of other federal or state laws to those activities.

Sincerely,

Catherine McGuire Chief Counsel

Incoming Letter:

March 22, 2004

Catherine McGuire, Esq. Chief Counsel and Associate Director Division of Market Regulation Securities and Exchange Commission 450 Fifth Street, N.W. Washington, D.C. 20549

Re: Physical Delivery for Customers Whose Security Futures Accounts are Carried by Notice-Registered Broker-Dealers; Request for No-Action Relief

Dear Ms. McGuire:

As you know, the Commodity Futures Modernization Act of 2000 (CFMA) amended the Commodity Exchange Act (CEA) and the federal securities laws to lift the ban on trading futures on single-stocks and narrow-based security indices (security futures products). The CFMA provides that these products are securities as well as futures and applies the broker-dealer registration requirements in Section 15 of the Securities Exchange Act of 1934 (Exchange Act) to persons engaging in security futures activities. The CFMA also amended the Exchange Act by adding a new Section 15(b)(11), which, in effect, provides for a simplified, notice registration process for any person already registered with the Commodity Futures Trading Commission (CFTC) as a futures commission merchant (FCM) or introducing broker (IB) if said person is a Member of NFA and is only required to register to effect transactions in security futures products.

NFA Member FCMs are trying to make arrangements to effectuate the process of making or taking delivery of physically settled security futures contracts on behalf of their customers on infrequent ocassions. A number of notice-registered broker-dealers would like to enter into omnibus arrangements for this sole purpose. However, both those notice-registered broker-dealers that want to originate and maintain omnibus accounts and those fully-registered broker-dealers that are considering carrying the accounts are concerned that regulators will take the position that using an omnibus account to effect delivery violates the securities laws under these circumstances. Therefore, NFA is asking the Commission staff to take a no-action position regarding firms that enter into such arrangements.

The process would work as follows. A customer taking delivery would initiate the delivery process, pay for the securities in full, and provide the notice-registered broker-dealer with instructions to either transfer the securities to a securities account at a fully-registered broker-dealer or to deliver the securities to such other location as the customer instructs. 1 A customer making delivery would transfer the securities directly to the special omnibus account and would provide the notice-registered broker-dealer with instructions on where to deliver the proceeds of the sale. Because the delivery process is accomplished through a special omnibus account, the delivery instructions would flow to the fully-registered broker-dealer through the notice-registered broker-dealer, and, under normal circumstances, only the notice-registered broker-dealer would communicate with the ultimate customer and know that customer's identity.

Although the fully-registered broker-dealer carrying the omnibus account would not have to know the customer's identity, the notice-registered broker-dealer would be required to provide the fully-registered broker-dealer with enough information to effect the delivery. For example, if the securities were to be transferred from the omnibus account to a securities account, the notice-registered broker-dealer would provide the fully-registered broker-dealer carrying the omnibus account with the name of the broker-dealer carrying the customer's securities account and the account number (but not the name) for that account.

If the customer taking delivery does not have a securities account, the notice-registered broker-dealer may recommend a fully-registered broker-dealer to the customer. However, the notice-registered broker-dealer would not receive any compensation, reimbursement of expenses, or other payment, however denominated, relating, directly or indirectly, to the referral or to any other activities the fully-registered broker-dealer performs on behalf of the customer. 2

Since the special omnibus account is simply an administrative device to facilitate deliveries, we believe the fully-registered broker-dealer should be able to rely on the notice-registered broker-dealer in matters involving the ultimate customers and should not have to supervise the notice-registered broker-dealer's activities, which would be limited to providing customers with information on depositing cash and securities in the account for delivery purposes and passing on instructions from customers regarding where to deliver the securities and cash those customers receive as a result of the delivery process. 3

NFA understands that this process is similar to one currently used for equity options deliveries except, of course, that the broker-dealer using the omnibus account for equity options is fully-registered. We believe that this process is also consistent with congressional intent when adopting the CFMA.

As noted above, the CFMA amended the Exchange Act to authorize FCMs to notice-register as broker-dealers in order to effect transactions in security futures products. Delivery provisions are included in exchange rules governing the terms of the futures contract, and delivery has always been considered an integral part of a physically-delivered futures contract. For example, a soybean transaction is not completed until the contract is closed by either offset or delivery, and delivery is not completed until the warehouse receipt and the purchase price have changed hands. Delivery is the last part of the futures transaction, and notice-registered broker-dealers should be able to complete that transaction on the infrequent occasions when delivery occurs just as they do for other futures contracts.

In addition, requiring notice-registered firms to identify their customers to fully-registered competitors before those customers can make or take delivery puts notice-registered broker-dealers at a significant competitive disadvantage. While some notice-registered firms may choose to enter into business arrangements where they give up this information, that decision should be dictated by business rather than regulatory considerations.

NFA recognizes that notice-registration as a broker-dealer does not authorize those entities to buy or sell the underlying securities to or for customers, even in connection with the delivery process or in connection with obtaining margin collateral. 4 We also recognize that notice-registered broker-dealers cannot be allowed to use the futures process as a guise for conducting business in the underlying securities. 5 Furthermore, we realize that practical and regulatory considerations in the clearing process for the underlying securities dictate that a notice-registered broker-dealer cannot make or accept delivery unless it does so through a fully-registered broker-dealer that is a member of the National Securities Clearing Corporation/Depository Trust Corporation (NSCC/DTC). We believe, however, that an FCM that is notice-registered as a broker-dealer should be able to maintain a special omnibus account with a fully-registered broker-dealer in order to effectuate the process of making or taking delivery of physically settled security futures contracts on behalf of their customers on infrequent occasions. 6 Furthermore, we believe that this procedure is consistent with previous positions taken by the Commission.

On August 21, 2001, the SEC issued final rules regarding notice registration as broker-dealers. In that release, the SEC stated:

In adopting Rule 15a-10, we recognize that we may need to clarify the activities in which a Security Futures Product Broker-Dealer may engage in reliance on the rule. One commenter asked us to confirm that a Security Futures Product Broker-Dealer may accept and deliver securities in connection with security futures products that are "physically settled" .... We expect to resolve questions relating to the specific operation of particular security futures products when we review the filings made by National Securities Exchanges, National Securities Associations, and Security Futures Product Exchanges to list and trade security futures products....

We note, however, that Exchange Act Section 6(g)(5)(B) permits limited trading on a principal-to-principal basis in security futures products to begin on August 21, 2001 or such later date by which a limited purpose national securities association has satisfied the requirements of Exchange Act Section 15A(k)(2). We will not take enforcement action under Exchange Act Section 15(a) against a Security Futures Product Broker-Dealer that is not registered as a full broker-dealer and accepts and occasionally delivers the underlying securities upon the expiration of a security futures product that it has obtained in a transaction permitted by Section 6(g)(5)(B) and is effected between today and December 21, 2001.

Securities Exchange Act Release No. 44730, 66 Fed. Reg. 45138, 45141 (Aug. 27, 2001) (footnotes omitted).

The SEC also addressed the delivery of physically-settled security futures contracts in footnote 114 of Securities Exchange Act Release No. 46101. In that release, the Commission stated:

The Commission already has addressed the issue of a notice-registered broker-dealer handling certain securities upon expiration of a security future that is physically-settled. As we stated when we adopted rules to permit notice registration, a notice-registered broker-dealer that accepts and occasionally delivers the underlying securities upon the expiration of a security future is not acting as a broker or dealer with respect to those securities . It therefore is not required to register as a full broker-dealer. Because most futures transactions are generally closed out by offsetting transactions, and not by physical settlement, this should not be an issue for most notice-registered broker-dealers. A futures commission merchant that routinely closes out its transactions in security futures products by physical delivery, however, should register as a full broker-dealer. See Securities Exchange Act Release No. 44730 (August 21, 2001), 66 FR 45138 (August 27, 2001).

Commission Guidance on the Application of Certain Provisions of the Securities Act of 1933, the Securities Exchange Act of 1934, and Rules Thereunder to Trading in Security Futures Products, 67 Fed. Reg. 43234, 43246, fn. 114 (June 27, 2002) (emphasis added).

For the reasons given above, NFA is asking Commission staff to provide assurance that the staff will not recommend enforcement action if an NFA Member FCM notice-registered as a broker-dealer originates and maintains, for the purposes described above, a special omnibus account that meets all of the criteria set forth below without registering as a fully-registered broker-dealer under Section 15(a) of the Exchange Act. The criteria are as follows:

The Member originating and maintaining the special omnibus account is a fully-registered FCM and a notice-registered broker-dealer;

The Member carrying the special omnibus account is a fully-registered broker-dealer and a member of the Options Clearing Corporation and NSCC/DTC;

The notice-registered broker-dealer does not purchase or sell the underlying securities for or on behalf of customers and does not receive any compensation, reimbursement of expenses, or other payment, however denominated, relating, directly or indirectly, to the referral of customers to a fully-registered broker-dealer for purposes of making or taking delivery of physically settled security futures contracts, any other activities the fully-registered broker-dealer performs on behalf of referred customers, or any other activities related to the omnibus account;

The notice-registered broker-dealer does not solicit customers based on its ability to effectuate physical delivery of securities for its customers;

The notice-registered broker-dealer does not charge fees for delivery other than to recover its costs for such delivery;

The delivery is initiated by a customer of the notice-registered broker-dealer;

Customers taking delivery instruct the notice-registered broker-dealer to either transfer the securities to an account at a fully-registered broker-dealer or deliver the securities to some other location specified by the customer;

Customers taking delivery pay for the securities in full (i.e., no margin loans);

Customers making delivery transfer the securities directly from a securities account to the special omnibus account held by the fully-registered broker-dealer;

The notice-registered broker-dealer gives standing instructions from its customers to the fully-registered broker-dealer by the last trading day;

The standing instructions include the name of the broker-dealer and the number (but not the name) of the account where the securities are to be sent or the information necessary to deliver the securities to another location specified by the customer;

The securities are delivered in street name and are promptly transmitted from the special omnibus account;

The notice-registered broker-dealer does not condition making or taking delivery on the customer's use of a particular fully-registered broker-dealer to carry the customer's securities account;

The notice-registered broker-dealer discloses the customer's identity to the fully-registered broker-dealer if the fully-registered broker-dealer has reason to believe that the customer is misusing the delivery process or violating the securities laws; and

The notice-registered broker-dealer does not make or take delivery on behalf of customers except on infrequent occasions.

If you have any questions or need any additional information, please contact me (312-781-1413 or tsexton@nfa.futures.org), Kathryn Camp (312-781-1393 or kcamp@nfa.futures.org), or Regina Thoele (312-781-1327 or rthoele@nfa.futures.org).

Very truly yours,

Thomas W. Sexton Vice President and General Counsel

cc: Daniel P. Fisher

Endnotes

1 The customer would provide the instructions early enough to allow the notice-registered broker-dealer to give standing instructions to the fully-registered broker-dealer by the last trading day.

2 A customer that already has a securities account may choose to carry its security futures account at a notice-registered broker-dealer for a number of reasons (e.g., the customer has an existing futures account at the notice-registered broker-dealer, the fully-registered broker-dealer has chosen not to offer security futures to its customers, or the customer believes that one firm provides better service for his futures transactions while the other provides better service for his securities transactions).

3 Since the account is for the benefit of customers, the fully-registered broker-dealer would, however, treat it as a customer account rather than as a proprietary account of the notice-registered broker-dealer.

4 Rule 3a43-1 permits the purchase and sale of government securities for margin purposes under certain conditions.

5 NFA's audit programs check to make sure that delivery is not occurring more often than would be expected considering the infrequency of delivery in the futures markets and the type of customer. (Historically, futures "market makers" have a higher incidence of deliveries than retail customers because market makers may take delivery temporarily if the economics dictate, while FCMs strongly discourage retail customers from taking delivery at all.) If delivery occurs too often, the notice-registered broker-dealer will be subject to discipline by NFA for violating NFA Compliance Rule 2-4 and Section 15 of the Securities Exchange Act of 1934. NFA's promotional material surveillance and audit programs also check to make sure that notice-registered broker-dealers do not solicit customers based on their ability to effectuate physical delivery, and NFA's audit programs would also detect activities by the notice-registered broker-dealer to buy or sell the underlying securities to or for customers. This conduct would be subject to discipline under those same sections.

6 There are currently 38 FCMs that are notice-registered as broker-dealers. Although there are over 500 notice-registered broker-dealers, the rest are IBs, which cannot carry customer funds or accounts.

http://www.sec.gov/divisions/marketreg/mr-noaction/nfa032204.htm

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Modified: 02/09/2005