January 27, 2012
As a proud Kansan, there is no place I would rather be today than speaking to a group of Wheat Growers. Thank you for inviting me today to discuss the bankruptcy of MF Global and the regulatory issues related to the protection of customer segregated funds.
On November 9th, the Commission voted to make me the Senior Commissioner with respect to MF Global Matters. This authorizes me to exercise the executive and administrative functions of the Commission solely with respect to:
• The pending enforcement investigation;
• The pending bankruptcy case in the Southern District of NY involving MF Global, Inc. (which is the broker-dealer/futures commission merchant);
• The pending bankruptcy case in the Southern District of NY involving MF Global Holdings, Ltd. (which is the parent company); and
• Other actions to locate or recover customer funds or determine the reasons for shortfalls in the customer accounts.
The past three months have been enormously challenging. I have heard from hundreds of MF Global customers, many of whom have differing circumstances but never anticipated that their segregated accounts were at risk of suffering losses not associated with trading. I, along with the hardworking staff of the CFTC, certainly understand the severe hardship this bankruptcy has caused. While our current focus is returning as much money as possible to customers, we are expending an enormous amount of effort to locate the missing customer funds and pursuing the enforcement investigation. Today, I will be unable to comment on the specifics of the law enforcement investigations, but will instead focus on the bankruptcy proceedings and the legal requirements surrounding the segregation of customer funds held at futures commission merchants (FCMs).
Pending Bankruptcy Cases
Many have questioned why an FCM bankruptcy would take place in a proceeding under the Securities Investors Protection Act of 1970 (SIPA). Under SIPA, the Securities and Exchange Commission (SEC) has the authority to refer an entity registered as a broker-dealer (BD) (whether or not such entity is also registered as an FCM) to the Securities Investors Protection Corporation (SIPC) if there is reason to believe that the entity is in or is approaching financial difficulty. SIPC may initiate a liquidation proceeding to protect customers of an insolvent BD when certain statutory criteria are met. In this instance, the liquidation was initiated on October 31st. The CFTC supported getting MF Global into a bankruptcy proceeding as quickly as possible, and MF Global consented to being placed into the SIPA liquidation proceeding. When a BD is also a registered FCM, as MF Global was, there is one dually-registered entity and the entire entity gets placed into liquidation. Because there is one entity, it is not possible to initiate a SIPA liquidation of the BD, and a separate bankruptcy proceeding for the FCM. It is important to note, however, that when a dually-registered BD/FCM is placed into a SIPA liquidation proceeding, the relevant provisions and protections of the Bankruptcy Code, the Commodity Exchange Act (“CEA”), and the Commission’s regulations apply to commodity accounts just as they would if the entity were solely an FCM and in a non-SIPA bankruptcy proceeding.
An obvious point to make is that if a firm is involved in a bankruptcy proceeding, something must have gone very wrong. Bankruptcy proceedings can be very complicated and at times, messy. This can be magnified when the bankruptcy is among the largest in history and there are serious questions about the location of customer funds. The Commission is no stranger to FCM bankruptcies. Lehman Brothers and Refco are the two most recent FCM bankruptcies. While the Lehman Brothers bankruptcy was monumental in scale, and the Refco bankruptcy involved serious fraud at the parent company, commodity customers did not lose their money at either firm. In both instances, commodity customer accounts were wholly intact, that is, they contained all open positions and all associated segregated collateral. That being the case, customer accounts were promptly transferred to healthy FCMs, with the commodity customers having no further involvement in the bankruptcy proceedings. Unfortunately that is not what happened at MF Global because customer accounts were not intact.
In FCM bankruptcies, commodity customers have an exclusive right to customer property. This includes, without limitation, segregated property, property that was illegally removed from segregation and is still within the debtor’s estate, and property that was illegally removed from segregation and is no longer within in the debtor’s estate, but is clawed-back into the debtor’s estate by the Trustee. If the customer property as I just described is insufficient to satisfy in full all the claims of customers, Part 190 of the Commission’s regulations allows other property of the debtor’s estate to be classified as customer property to make up any shortfall. A parent or affiliated entity, however, generally would not be a “debtor” unless customer funds could be traced to that entity. As you likely know, MF Global’s parent company is involved in a separate bankruptcy proceeding pending in New York. The Commission has been monitoring that proceeding to ensure that commodity customers’ rights are protected. The Commission has been adamant that commodity customers must be made whole in preference to substantially all other claims, and just last week, the Commission filed a brief reinforcing that position.
When a firm initially goes into bankruptcy, there can be uncertainty and delay when it comes to returning customer funds. In this instance, the Commission pushed from the very beginning for positions to be transferred and customer funds to be returned. Within the first weeks of the BD/FCM bankruptcy, the Trustee, with the encouragement and assistance of the CFTC, transferred nearly all positions of customers trading on U.S. commodity futures markets, and transferred approximately $2 billion of customer property. On November 29th, the Trustee moved to transfer an additional $2.1 billion back to customers, to be used to “top up” all commodity customers to at least two-thirds of their account values as reflected on the books and records of MF Global, Inc. The Commission fully supported the Trustee’s motion, and in December, the Bankruptcy Court granted the motion and the resulting “top up” amount was closer to 72% except for customers claiming property in the form of physical assets. The Bankruptcy Court has scheduled a hearing for January 30, 2012 to resolve outstanding factual issues with respect to these claims.
Despite the initial distributions to customers, all customers must file a completed claim form with the Trustee by January 31, 2012 in order to receive maximum protection under the law and be considered for further distributions. This process allows the Trustee to legally verify how much each customer is owed after the accounting has been finalized.
FCM Investment of Customer Funds
An FCM is authorized to invest funds that are in customer segregated accounts. This authorization is found in Section 4d of the CEA and in Commission Regulation 1.25, which requires that all permitted investments be “consistent with the objectives of preserving principal and maintaining liquidity.”
In thinking about the investment of customer funds, it may be helpful to draw an analogy to a savings account at a bank. Let’s say someone opens a savings account with $1,000 and the bank agrees to pay 0.25% interest annually. That $1,000 is not just sitting at the bank waiting for the depositor to come and get it. The bank invests that money, or loans it to others, etc., with the goal of earning a rate of return greater than the 0.25% interest the bank is obligated to pay the depositor. Very simply stated, if the bank earns a rate of return greater than 0.25%, that is net revenue for the bank. If the bank earns a rate of return less than 0.25%, there is a net loss.
Broadly speaking, the investment of customer funds by an FCM is similar, but there are critical safeguards and restrictions placed on FCMs. Section 4d of the CEA and Commission Regulation 1.25 list the only permissible investments an FCM can make with customer funds. The Commission has been, and continues to be, mindful that customer segregated funds must be invested in a manner that minimizes their exposure to credit, liquidity, and market risks, both to preserve their availability to customers and clearinghouses and to enable investments to be quickly converted to cash at a predictable value. If any losses occur as a result of an investment, the losses are borne by the FCM, not the customer.
It is also important to note that the value of the customer segregated account must remain intact at all times. In other words, when an FCM invests customer funds, that actual investment, or collateral equal in value to the investment, must remain in the customer segregated account. If customer funds are transferred out of the segregated account to be invested by the FCM, the FCM must make a simultaneous transfer of assets into the segregated account. An FCM cannot take money out of a segregated account, invest it, and then return the money to the segregated account at some later time. If an FCM does that, it has violated the law.
Finally, a lot has been said about the investment of customer funds in foreign sovereign debt. Prior to recent changes made to Regulation 1.25, FCMs were allowed to invest customer funds in highly-rated foreign sovereign debt, but only to hedge foreign currency risk posed by fluctuations in a particular foreign currency posted by the customer to the FCM. Such investments were strictly limited to the amount of a foreign nation’s currency that the customer posted. Investment in foreign sovereign debt for purposes of speculation was never allowed under Regulation 1.25, and Regulation 1.25 does not, and never has, had anything to do with investments made by a BD. It has been widely reported that the BD arm of MF Global made risky bets in foreign sovereign debt through off-balance sheet “repo-to-maturity” transactions. That activity was subject to the oversight of the SEC and the Financial Industry Regulatory Authority, not the CFTC.
Customer Accounts at FCMs
When a customer opens a trading account at an FCM, Commission regulations require the customer to be provided with a risk disclosure statement that generally centers on market risk, market volatility, and leverage. Pursuant to Commission Regulation 1.55(b)(6), the required risk disclosure statement must also include the following: “You should consult your broker concerning the nature of the protections available to safeguard funds or property deposited for your account.” There are no required disclosures concerning how customer funds can be invested by an FCM.
Commission Regulation 1.20 requires that accounts holding segregated funds be titled specifically to identify the contents of the account as separate from the ownership of the FCM. In addition, FCMs must obtain letters from their depositories acknowledging that the depositories cannot exercise any rights of offset to such accounts for obligations of the FCM.
Commission Regulation 1.12 requires FCMs to notify the Commission immediately of an occurrence of under-segregation. FCMs also must notify the Commission of instances of significant margin calls (such as a margin call to a customer, which if not made, would put fellow customers at risk if an adequate buffer or “excess segregation” was not in segregated accounts).
A customer is required to post margin to support futures positions. Generally, a customer deposits more than the minimum initial margin required for the positions established. The additional funds provide a buffer so a customer can place trades without posting additional margin, and lessen the likelihood of repeated margin calls or having positions liquidated if margin calls are not met on a timely basis. In addition to customers depositing additional margin, in practice, FCMs typically maintain significant amounts of their own capital as “excess segregated funds.” By doing this one customer’s deficit due to market moves or unmet margin calls is covered by the FCM’s buffer and does not result in one customer’s funds being exposed to the credit risk of another customer. FCMs are not obligated to provide excess segregated funds, but given the legal obligation at all times to have sufficient funds in segregated accounts to cover all liabilities to customers, FCMs generally find it wise to have a buffer.
A customer may withdraw excess margin funds or use such funds as the customer deems appropriate. This would include using the funds for non-futures related transactions with the FCM. If the excess funds held by the FCM are used in a manner directed by the customer such that the funds are not maintained in a futures segregated account, the funds would not have the protections afforded segregated customer funds under the Bankruptcy Code and Part 190 of the Commission’s Regulations.
Oversight of FCMs
FCMs are subject to CFTC-approved minimum financial and reporting requirements that are enforced in the first instance by a designated self-regulatory organization (DSRO), for example, the Chicago Mercantile Exchange or the National Futures Association. DSROs also conduct periodic compliance examinations on a risk-based cycle every 9 to 15 months. The requirements of DSRO examinations are contained in Financial and Segregation Interpretations 4-1 and 4-2, which are specified as application guidance to Core Principle 11 (Financial Integrity) for designated contract markets. The Commission has proposed codifying the essential components of these interpretations into an amended Commission Regulation 1.52.
An examination of segregation compliance is mandatory in each examination (certain other components need not be included in every examination). This examination includes a review of the depository acknowledgement letters and the account titles of segregated accounts (unless unchanged from the prior examination); verifying account balances, and ensuring that investment of customer funds is done in accordance with Commission Regulation 1.25.
Commission Regulation 1.10 requires FCMs to file monthly unaudited financial reports with the Commission and the DSRO. These reports include the FCM’s segregation and net capital schedules, and any “further material information as may be necessary to make the required statements and schedules not misleading.” Each financial report must be filed with an oath or attestation, and for a corporation, the oath must be by the CEO or CFO.
Commission Regulation 1.16 requires FCMs to file annual certified financial reports with the Commission and the DSRO. The audits require, among other things, that if a new auditor is hired, the new auditor must notify the Commission of certain disagreements with statements made in reports prepared by prior auditors. Auditors also must test internal controls to identify and report to the Commission any “material inadequacy” that could reasonably be expected to: inhibit a registrant from completing transactions or promptly discharging responsibilities to customers or other creditors; result in material financial loss; result in material misstatement of financial statements or schedules; or result in violation of the Commission’s segregation, secured amount, recordkeeping or financial reporting requirements.
Although significant progress has been made over the past three months, a number of unanswered questions still remain. All of the information we learn during these aspects of our work will be relevant to the Commission as it considers “lessons learned” and any policy responses or regulatory changes. Chairman Gensler has directed Commission staff to develop recommendations for policy and regulatory changes that are necessary in the aftermath of MF Global. In addition, many have called for a task force that includes industry experts and stakeholders such as you to work with the Commission as it moves forward with initiatives to enhance the protection of customer funds. I support the formation of such a task force and hope the Commission decides to establish one very soon.
The Commission has a great deal of work ahead of it to get customer funds back where they need to be, to determine what went wrong at MF Global, and to determine whether to prosecute any violations of the Act. I want to assure you all that we are working as expeditiously as possible, and first and foremost in our minds are the customers who trusted MF Global and the system, and who lost so much.
Thank you. I am happy to answer any questions you may have.
Last Updated: January 27, 2012