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Senator Lincoln Details Protections for Retail Commodities Customers in Dodd-Frank Act

By Jim Hamilton

Section 742 of the Dodd-Frank Act includes several important provisions to enhance the protections afforded to customers in retail commodity transactions. Senator Lincoln highlighted such provisions. First, Section 742 clarifies the prohibition on off-exchange retail futures contracts that has been at the heart of the Commodity Exchange Act throughout its history.

In recent years, there have been instances of fraudsters using what are known as rolling spot contracts with retail customers in order to evade the CFTC?s jurisdiction over futures contracts. These contracts function just like futures, but the Seventh Circuit in the 2004 CFTC v. Zelener case, based on the wording of the contract documents, held them to be spot contracts outside of CFTC jurisdiction. The CFTC Reauthorization Act of 2008, which was enacted as part of that year?s Farm Bill, clarified that such transactions in foreign currency are subject to CFTC anti-fraud authority. It left open the possibility, however, that such Zelener-type contracts could still escape CFTC jurisdiction if used for other commodities such as energy and metals. Section 742 corrects this by extending the Farm Bill?s ??Zelener fraud fix?? to retail off exchange transactions in all commodities.

Further, a transaction with a retail customer that meets the leverage and other requirements set forth in Section 742 is subject not only to the anti-fraud provisions of CEA Section 4b (which is the case for foreign currency), but also to the on-exchange trading requirement of CEA Section 4(a), as if? the transaction was a futures contract. As a result, such transactions are unlawful, and may not be intermediated by any person, unless they are conducted on or subject to the rules of a designated contract market subject to the full array of regulatory requirements applicable to on-exchange futures under the CEA. Retail off-exchange transactions in foreign currency will continue to be covered by the ??Zelener fraud fix?? enacted in the Farm Bill. Further, cash or spot contracts, forward contracts, securities, and certain banking products are excluded from this provision in Section 742, just as they were excluded in the Farm Bill. Section 742 also addresses the risk of regulatory arbitrage with respect to retail foreign currency transactions.

Under the CEA, several types of regulated entities can provide retail foreign currency trading platforms, among them, broker-dealers, banks, futures commission merchants, and the category of retail foreign exchange dealers that was recognized by Congress in the Farm Bill in 2008. Section 742 requires that the agencies regulating these entities have comparable regulations in place before their regulated entities are allowed to offer retail foreign currency trading. According to Senator Lincoln, this will ensure that all domestic retail foreign currency trading is subject to similar protections.

Finally, Section 742 also addresses a situation where domestic retail foreign currency
firms were apparently moving their activities offshore in order to avoid regulations required by the National Futures Association. It removes foreign financial institutions as an acceptable counterparty for off-exchange retail foreign currency transactions under section 2(c) of the CEA. Foreign financial institutions seeking to offer them to retail customers within the United States will now have to offer such contracts through one of the other legal mechanisms available under the CEA for accessing U.S. retail customers. (Cong. Record, July 15, 2010, S59124).

Full post as published by Jim Hamilton's World of Securities Regulation on August 15, 2010 (boomark / email).