The CFTC plays a critical role in the liquidation of a commodity broker under Subchapter IV of chapter 7 of the Bankruptcy Code (Code). Although Subchapter IV sets out the essential provisions governing the liquidation of a commodity broker in bankruptcy, the CFTC is authorized under section 20 of the Commodity Exchange Act (CEA),"notwithstanding the Code," to adopt rules that provide, inter alia, that: (1) certain cash, securities, other property, or commodity contracts are to be included in or excluded from customer property or member property; and (2) the method by which the business of such commodity broker is to be conducted or liquidated after the date of the filing of the petition under the Code.

Pursuant to this authority, the CFTC adopted Part 190 of its rules governing the liquidation of commodity brokers. Over the years, certain provisions of the Part 190 rules have been amended to accommodate specific issues or statutory changes. For example, when the CFTC adopted Part 22 of its rules relating to cleared swaps, Part 190 was amended to establish the cleared swaps customer account as a separate account class under the rules. The bankruptcies of MF Global Inc. in 2011 and Peregrine Financial Group Inc. the following year, however, brought to the fore several significant shortcomings in the rules, which demanded a more thorough evaluation of the rules.

The Proposal

To this end, by unanimous vote, the CFTC proposed a comprehensive refreshing of Part 190 rules, although no materially new concepts were introduced. Even new subpart C, governing the liquidation of a derivatives clearing organization (DCO), relies in significant part on the default management rules and procedures and recovery and wind-down plans adopted by the relevant DCO in accordance with CFTC Rules 39.16 and 39.39, respectively, and submitted to the CFTC for review.

Many proposed amendments solely reflect the evolution of communications and recordkeeping since 1983. For example, the Proposal would replace the requirement that a trustee provide certain notices to customers of a bankrupt futures commission merchant (FCM) by publication in "a newspaper of general circulation . . . serving the location of each branch office of the commodity broker" with a more general requirement that the trustee establish and follow procedures "reasonably designed for giving adequate notice to customers." The Proposal would further recognize that documents of title, including warehouse receipts and shipping certificates representing physical delivery commodities, are frequently held in electronic form.

More substantively, the Proposal provides a more fulsome roadmap for a trustee appointed to liquidate a commodity broker, which confirms and clarifies the CFTC's policies and its interpretations of the Part 190 rules that the CFTC has developed, in part, in response to past FCM bankruptcies. The Proposal also seeks to address certain ambiguities that have complicated past bankruptcies and avoid future ambiguities "in order to accomplish better and more reliably the goals of promptly and cost-effectively resolving commodity broker bankruptcies while mitigating systemic risk and protecting the commodity broker's customers."

Such a roadmap is critical for any trustee, but, as the CFTC notes, it is particularly important when the trustee may not be familiar with the business of an FCM and may be operating primarily under a different statute. For example, when an FCM is also registered with the Securities and Exchange Commission as a broker-dealer, the trustee will likely be appointed and be guided primarily by the Securities Investors Protection Act (SIPA). However, SIPA provides that, in the case of broker‑dealer that is also an FCM, the trustee "shall be subject to the same duties as a trustee in a case under chapter 7 of title 11" to the extent consistent with SIPA or as otherwise ordered by the court. 

Similarly, in the event of the resolution of a DCO under orderly liquidation provisions of Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), the Federal Deposit Insurance Corporation (FDIC), as receiver for the DCO, must apply the provisions of subchapter IV of chapter 7 of the Code with respect to the distribution of customer property and member property. As the CFTC notes, therefore, "in developing resolution strategies for a DCO while mitigating claims against the FDIC as receiver, it is important to understand what would happen if the DCO was instead liquidated pursuant to chapter 7 of the [Code] (and this part 190)."

By confirming and clarifying the CFTC's policies and interpretations and addressing ambiguities in its current rules, the Proposal is further designed to enhance legal certainty and protect the Part 190 regulatory regime from successful legal challenge. In his remarks during the CFTC's April 14 virtual meeting on the Proposal, Robert Wasserman, Chief Counsel of the Division of Clearing and Risk, noted the importance of exposing the CFTC's interpretations of Part 190 to public notice and comment, especially in light of the U.S. Supreme Court's decision Kisor v Wilke 588 US ____ (2019). This case, although affirming previous decisions affording deference to an agency's interpretation of its own rules, also established a multi-factor test that the interpretation must pass, which effectively narrowed the circumstances in which a court should grant deference. Among other requirements, Kisor holds that an interpretation must be the agency's "authoritative or official position" and "in some way implicate its substantive expertise."

To this end, new subpart A demonstrates that Congress has recognized the CFTC's substantive expertise with regard to commodity broker liquidations by vesting the CFTC with specific authority to adopt rules in this regard, "notwithstanding the Code." It further confirms that the rules, policies and interpretation established therein represent the CFTC's authoritative and official position.

Included among such policies and interpretations, proposed Rule 190.00 confirms the CFTC's position, for example, that:

• certain contracts are not "commodity contracts" for purposes of Part 190, including: (1) options on commodities (including swaps that are subject to Part 32 of the CFTC's rules) that are not centrally cleared; (2) forward contracts that are not centrally cleared; (3) security futures contracts that are held in a securities account; (4) retail foreign currency transactions; and (5) retail commodity transactions;
• the rules do not apply to commodity options dealers or leverage transaction merchants, since there are no such dealers at this time;
• public customer positions should be transferred where possible and not liquidated;
• in the context of portfolio margining or cross margining programs, commodity contracts and associated collateral will be treated as part of the account class in which, consistent with CFTC rules, they are held (i.e., the so-called "home field" rule); and
• the delivery provisions of Part 190 are intended (1) to allow deliveries to be completed in accordance with the rules and established practices of the relevant contract market or clearing organization and (2) to favor delivery, where practicable, outside administration of the debtor's estate.

A chart summarizing all of the provisions in the Proposal is set out at the end of this advisory. Select provisions of subpart B, Futures Commission Merchant as Debtor, and subpart C, Derivatives Clearing Organization as Debtor, which may be of particular interest, follow.

Subpart B, Futures Commission Merchant as Debtor

Three proposed rules relating to the scope of customer property stand out.

Letters of credit. The CFTC confirms that letters of credit may be drawn to their full value by a trustee, if necessary, in the event of a shortfall in customer funds. This is not a new requirement; current Rule 190.08(a)(1)(i)(E) provides that the full proceeds of a letter of credit may be included in customer property. However, the Proposal is far more detailed and provides that the trustee may request that a customer deliver substitute customer property with respect to any letter of credit received, acquired or held to margin, guarantee, secure, purchase or sell a commodity contract. If a customer fails to provide substitute customer property within a reasonable time specified by the trustee, the trustee may, if the letter of credit has not expired, draw upon the full amount of the letter. The Proposal further provides that the trustee will treat any portion that is not drawn upon (less the value of any substitute customer property delivered by the customer) as having been distributed to the customer for purposes of calculating entitlements to distribution or transfer. 

Residual interest and other FCM assets. The CFTC confirms that a trustee may apply a debtor FCM's residual interest on deposit in a customer account in the event of a shortfall in the customer account. More broadly, customer property includes any cash, securities, or other property in the debtor's estate, but only to the extent that the customer property under the other definitional elements is insufficient to satisfy in full all claims of the FCM's public customers. This includes "customer property," as defined in section 16(4) of SIPA that remains after allocation in accordance with section 8(c)(1)(A)-(D) of SIPA and that is allocated to the debtor's general estate in accordance with section 8(c)(1) of SIPA.

In proposing these latter provisions, the CFTC took note the decision of the Bankruptcy Court for the Northern District of Illinois in In Re Griffin Trading Company, in which the Court ruled that the Commission exceeded its statutory authority by adopting current Rule 190.08(a)(1)(ii)(J), which similarly provides that customer property includes "cash, securities or other property of the debtor's estate" and held that it was invalid. Notwithstanding the Court's decision, which was subsequently vacated on appeal pursuant to a settlement reached by the parties, the CFTC reaffirmed its view that section 20 of the CEA provides it with the authority to include proposed Rule 190.09(a)(1)(ii)(L) in part 190.

Margin calls to undermargined public customer accounts. Additionally, the Proposal updates an existing rule regarding margin calls made by a trustee to undermargined accounts of public customers. As proposed, a trustee shall "as soon as practicable" liquidate all open commodity contracts in any account that is in deficit, where any mark-to-market calculation would result in a deficit; or where a customer fails to meet a margin call made by the trustee "within a reasonable time." Borrowing from guidance in relevant court decisions, the Proposal defines a reasonable time "absent exigent circumstances… shall be one hour or such greater period not to exceed one business day, as determined by the trustee." However, the Proposal makes clear that less one hour would be reasonable if such exigent circumstances apply in the trustee's discretion. 

Subpart C, Derivatives Clearing Organization as Debtor

DCO default management rules. As noted earlier, the Proposal provides that the trustee should follow, to the extent practicable and appropriate, the DCO's pre-existing default management rules and procedures and recovery and wind-down plans that have been submitted to the CFTC. These rules, procedures, and plans will, in most cases, have been developed pursuant to CFTC Rules 39.16 and 39.39, respectively, subject to CFTC staff oversight. This approach relieves the trustee of the burden of developing, in the moment, models to address an extraordinarily complex situation.

The comment period for the Proposal expires on July 13, 2020.