ABA BUSINESS LAW SECTION DERIVATIVES & FUTURES LAW COMMITTEE WINTER MEETING 2018 PANEL: CLEARING / CUSTOMER PROTECTION / CCPS

Commodity Broker Bankruptcies and the ABA Part 190 Project Kathryn M. Trkla Foley & Lardner LLP (December 2017)

I. Introduction

The bankruptcy of a futures commission merchant (“FCM”) or derivatives clearing organization (“DCO”) organized in the U.S. is (with a notable exception) required to be handled as a “commodity broker” liquidation under subchapter IV of chapter 7 of the Bankruptcy Code (“Code”). The Part 190 Rules adopted by the Commodity Futures Trading Commission (“CFTC” or “Commission”) prescribe more specific requirements for such a proceeding. The CFTC first adopted the Part 190 Rules in 1983, and has amended them several times over the decades.

In February 2015, the Derivatives & Futures Law Committee and Business Bankruptcy Committee of the ABA Business Law Section jointly formed the Part 190 Subcommittee to conduct a careful review of the Part 190 Rules, with the plan to draft comprehensive revisions for the Commission’s consideration. The Part 190 Subcommittee submitted its proposed revisions to the CFTC on September 29, 2017, in connection with the Commission’s Project KISS initiative, in the form of model rules (“Model Part 190 Rules”).

This paper provides an overview of U.S. law provisions governing an FCM or DCO bankruptcy, along with an overview of the Part 190 project and Model Part 190 Rules.

II. FCM and DCO Bankruptcies

A. Statutory Background

1. Bankruptcy Code and CEA

a. Subchapter IV. Subchapter IV of chapter 7 of the Code1 is a special section of the Code that applies to “commodity broker” bankruptcies. As defined in Section 101(6) of the Code,2 the term “commodity broker” includes a person that is registered or required to register with the CFTC as an FCM and a person that is registered with the CFTC as a DCO. (The term also covers commodity options dealers and leverage transaction merchants, but those categories do not appear to have any relevance today.) A commodity broker is not eligible to file bankruptcy under chapter 11, which is the Code’s reorganization chapter.

1 11 U.S.C. §§ 761-767. 2 11 U.S. § 101(6). b. CEA § 20. Section 20 of the CEA3 authorizes the CFTC to adopt specific rules governing the trustee’s administration of a subchapter IV proceeding. In particular, Section 20(a) states that the CFTC may provide, by rule or regulation:

(1) that certain cash, securities, other property, or commodity contracts are to be included in or excluded from customer property or member property;

(2) that certain cash, securities, other property, or commodity contracts are to be specifically identifiable to a particular customer in a specific capacity;

(3) 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 such chapter, including the payment and allocation of margin with respect to commodity contracts not specifically identifiable to a particular customer pending their orderly liquidation;

(4) any persons to which customer property and commodity contracts may be transferred under section 766 of title 11; and

(5) how the net equity of a customer is to be determined.

Section 20(b) cross-references the definitions for the terms “commodity broker,” “commodity contract,” “customer,” “customer property,” “member property,” “net equity” and “security” set forth in subchapter IV.

c. CEA § 4d(f)(5). The definition of “commodity contract” in Section 761 of the Code expressly covers futures, but it does not expressly reference swaps.4 The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd- Frank” or “Dodd-Frank Act”) added new Section 4d(f)(5) to the CEA,5 which explicitly (albeit indirectly) brings swaps that are cleared within the Code definition. CEA § 4d(f)(5) states:

A swap cleared by or through a derivatives clearing organization shall be considered to be a commodity contract as such term is defined in section 761 of title 11, with regard to all money, securities, and property of any swaps customer received by a futures commission merchant or a derivatives clearing

3 7 U.S.C. § 24. 4 The Code definition does, though, cover “any other contract, option, agreement, or transaction that is similar to a contract, option, agreement, or transaction referred to in this paragraph” and, with respect to an FCM or a DCO, any “other contract, option, agreement or transaction” that is cleared by a DCO. 11 U.S.C. § 761(4)(F). 5 7 U.S.C. § 6d(f)(5). 2

organization to margin, guarantee, or secure the swap (including money, securities, or property accruing to the customer as the result of the swap).

d. Subchapter IV Cross-References to CFTC Authority. Various provisions in subchapter IV expressly recognize the CFTC’s rulemaking or other authority in other respects that are relevant to a commodity broker liquidation, specifically, the CFTC’s authority to:

• Further define the term “net equity.”6

• Protect transfers of commodity contracts and any cash or other property margining or securing the contracts that are made before the seventh day after the order for relief against avoidance by the trustee, by approving the transfer by rule or order either before or after the transfer.7

• Define customers whose accounts are classified as “proprietary accounts” of the commodity broker, and whose claims are thus treated as non-public customer claims that are subordinated to the claims of public customers.8

2. Potential Overlay of Securities Investor Protection Act of 1970

Most firms that are registered as FCMs are also registered with the Securities and Exchange Commission as securities broker-dealers. The bankruptcy proceeding of a dually-registered FCM/broker-dealer is typically initiated under the Securities Investor Protection Act of 1970 (“SIPA”),9 which means that the Securities Investor Protection Corporation will appoint a trustee that is responsible for liquidating both the FCM and broker-dealer businesses, subject to the Bankruptcy Court’s oversight. Notably, with respect to the FCM side, SIPA states that the trustee has the “same duties as a trustee” under subchapter IV, to “the extent consistent with the provisions of this chapter or as otherwise ordered by the court.”10

3. Orderly Liquidation Proceeding Under Title II of the Dodd-Frank Act

a. Potential Alternative for “Financial Companies.” It is possible that the insolvency of an FCM or DCO could be handled as an orderly liquidation proceeding under Title II of the Dodd-Frank Act, as an alternative to a subchapter IV proceeding. The Secretary of the Treasury has the authority to

6 11 U.S.C. § 761(17). 7 11 U.S.C. § 766(d)(2). 8 11 U.S.C. § 766(h). 9 15 U.S.C. §§ 78aaa et seq. 10 15 U.S.C. § 78fff-1(b). 3

initiate an orderly liquidation receivership against a “financial company”11 subject to first reaching certain determinations.12 If the Secretary initiates a Title II orderly liquidation proceeding, the Federal Deposit Insurance Corporation (“FDIC”) will be appointed to assume control over the liquidation of the company.

The FDIC has authority to assume virtually complete control over the liquidation, subject to only limited court oversight.13 It may create a “bridge financial company” to receive the transfer of selected assets and liabilities of the covered financial company, and may sell the company’s assets to one or more transferees without court approval or advance notice to creditors or shareholders.14

b. Subchapter IV is Relevant for Distributions. If the company being liquidated pursuant to Title II meets the Code’s commodity broker definition, the FDIC is required to apply the provisions of subchapter IV “in respect of the distribution to any customer of all customer property and member property,” as if it were a debtor for purposes of subchapter IV.15

c. Single Point of Entry. In December 2013, the FDIC announced and solicited comment on a “single point of entry” strategy for administering its orderly liquidation authority under Title II. If such a strategy is applied in a particular situation, the FDIC would be appointed receiver of the parent holding company, whose subsidiaries would remain open. The FDIC would then create a bridge financial company to which it would transfer assets from the receivership estate. If during the resolution process the FDIC determined that a subsidiary should be liquidated, the FDIC could permit that proceeding to occur under the

11 As defined in 12 U.S.C. § 5381(a)(11), a financial company is a company that (i) is incorporated or organized under U.S. federal or state law and (ii) is (A) a bank holding company, (B) a nonbank financial company supervised by the Board of Governors, (C) a company “predominantly engaged in activities that the Board of Governors has determined are financial in nature or incidental thereto for purposes of section 1843(k) of this title,” or (D) a subsidiary of a company described in any of the foregoing that is “predominantly engaged in activities that the Board of Governors has determined are financial in nature or incidental thereto for purposes of section 1843(k) of this title (other than a subsidiary that is an insured depository institution or an insurance company),” and (iii) is not chartered under and subject to the Farm Credit Act of 1971, or a governmental or regulated entity, as defined in section 4502 of this title. 12 The Secretary, after receiving recommendations from the FDIC and the Board of Governors of the Federal Reserve, must determine, among other things, that (i) the financial company is in default or in danger of default; (ii) its failure and resolution under other applicable law would “have serious adverse effects on financial stability” in the U.S.; (iii) a viable private sector alternative for preventing the default is not available; (iv) any effect on the claims or interests of creditors or certain other interested parties resulting from actions taken under Title II are appropriate given the impact that such actions would have on U.S. financial stability; and (v) any action taken would avoid or mitigate the adverse effects, taking into consideration the action’s effectiveness in “mitigating potential adverse effects on the financial system, the cost to the general fund of the Treasury, and the potential to increase excessive risk taking on the part of creditors” and certain other interested parties. 12 U.S.C. § 5383(b). 13 12 U.S.C. §§ 5390(a) and 5390(e). 14 12 U.S.C. §§ 5390(h) and 5390(a)(1)(G). 15 12 U.S.C. § 5390(m)(1)(B). 4

bankruptcy laws. Thus, it is possible that an FCM subsidiary of a parent holding company subject to a Title II proceeding could itself continue in operation or be liquidated in a subchapter IV proceeding.

B. Part 190 Rules

1. Background. The Commission first adopted the Part 190 Rules in 1983.16 Although the Commission has amended the rules several times over the decades, the existing rules continue to reflect the conceptual elements first established with respect to separating customers and customer property by account class, distributing customer property on a pro rata basis by account class with priority given to public customers, and transferring (porting) customer positions. The rules have also largely retained the same organizational structure.

2. FCM Commodity Broker Liquidation. The Part 190 Rules for the most part are designed for administrating a commodity broker liquidation of an FCM. The rules, in conjunction with subchapter IV, reflect the following overarching conceptual elements, or policies:

a. Attempt First to Port Customer Positions, Then Liquidate. The trustee should use his best efforts to transfer all open commodity contracts and related customer equity of the failed FCM’s public customers to another FCM (or FCMs) by the end of the seventh calendar day after the order for relief. The trustee is required to liquidate those positions that cannot be transferred.

b. Classification of Customer Property and Customers by Account Class. Part 190 separates pools of “customer property” by account class, and provides that customer property is shared only by the customers within a particular account class. The rules identify the following account classes,17 the first three of which correspond to separate customer funds segregation protections under the CEA and CFTC rules:

• Futures Account Class, which covers customers with accounts for trading futures or options on futures on or subject to the rules of a designated contract market (basically, a U.S. futures exchange).

• Foreign Futures Account Class, which covers customers with accounts for trading futures or options on futures on or subject to the rules of a foreign board of trade (i.e., a futures exchange located outside the U.S.).

• Cleared Swaps Account Class, which covers customers with accounts for clearing transactions in swaps through a CFTC-registered DCO.

16 Bankruptcy, 48 FR 8716 (March 1, 1983). 17 Part 190 also establishes an account class for leverage accounts, but that is only relevant for a commodity broker that is a leverage transaction merchant. 5

• Delivery Account Class, which covers customers that hold property in a delivery account for the purpose of making or taking delivery of physical commodities under commodity contracts.

c. Pro Rata Distribution of Customer Property by Account Class, With Priority to Public Customers. Section 766 of the Code requires the trustee to “distribute customer property ratably to customers on the basis and to the extent of such customers’ allowed net equity claims, and in priority to all other claims.”18 As explained above, Part 190 provides for separate classification and distribution of customer property by account class. Part 190 also makes an important distinction between the failed FCM’s public customers and non-public customers (i.e., affiliates or other insiders whose accounts are classified as proprietary under CFTC Rule 1.3(y)), and gives priority to public customers over non-public customers in the distribution of customer property in a particular account class. Thus, if the customer funds pool for a particular customer account class is insufficient to satisfy the net equity claims of the public customers in the account class, the shortfall will be shared pro rata by the public customers, and the non-public customers in the account class will not receive any distribution so long as there is such a shortfall.

d. DCO Commodity Broker Liquidation. The Part 190 Rules apply generally to the liquidation of any type of commodity broker, with little differentiation. As mentioned, though, the rules are largely tailored to the liquidation of an FCM. The one exception is Rule 190.09, which specifies what constitutes “member property” for purposes of a commodity broker liquidation of a DCO.

III. The Part 190 Project

1. Background. As mentioned, the Part 190 Subcommittee was formed in February 2015. The committee is co-chaired by Vince Lazar (on behalf of the Business Bankruptcy Committee) and Kathryn Trkla (on behalf of the Derivatives and Futures Law Committee). The committee has over 45 members, including attorneys at law firms, FCMs, DCOs and exchanges, government agencies and industry associations, and includes attorneys who have served as, or represent, trustees in FCM bankruptcy proceedings. Over the course of the project, the Part 190 Subcommittee prepared a detailed section-by-section analysis of the existing rules, along with a master list of issues that it addressed through working groups. The Part 190 Subcommittee also held three in-person meetings and had numerous planning and progress update calls. The Part 190 Subcommittee went through several rounds of drafting to produce the Model Part 190 Rules that were submitted to the Commission on September 29th in connection with the Commission’s Project KISS initiative.19

18 11 U.S.C. § 766(h). 19 Project KISS (Request for Information), 82 FR 23765 (May 24, 2017). The FIA and ISDA each expressed support for the Model Part 190 Rules in their respective Project KISS submissions to the Commission. 6

2. Overview of the Model Part 190 Rules. The Part 190 Subcommittee is proposing comprehensive changes to the existing Part 190 Rules, but also adhered to the conceptual elements of the existing rules described above. The Model Part 190 Rules include the following changes, among others:

a. Reorganization. The Model Part 190 Rules are organized into three subparts: Subpart A, General Provisions; Subpart B, Debtor is a Futures Commission Merchant; and Subpart C, Clearing Organization as Debtor. The Part 190 Subcommittee believes that this organization will facility application of the rules, by identifying the relevant circumstances in which different rules apply.

b. Limiting Commodity Brokers to FCMs and DCOs and Commodity Contracts to Cleared Contracts. The Model Part 190 Rules are limited in scope to commodity brokers that are FCMs or DCOs, with respect to commodity contracts that are cleared. The subchapter IV provisions apply to other types of commodity brokers beyond FCMs and DCO, specifically, to commodity options dealers and leverage transaction merchants, and to the types of non- cleared commodity contracts in which they deal. Those categories of commodity broker do not appear to have any relevance today, and thus the Part 190 Subcommittee recommends excluding them from the scope of the rules.

c. Context Rule. The Part 190 Subcommittee proposes to include a new general rule (in Subpart A) that provides context and describes the general framework of the Part 190 Rules. The rule is intended to aid a trustee or bankruptcy court in understanding the specific requirements in the other rules, which may be of particular value if the trustee or court does not have extensive experience with the regulation of clearing and customer funds segregation under the CEA and CFTC rules.

d. Clearing Relationships. The Model Part 190 Rules are designed to address different clearing relationships and the different considerations they raise (e.g., liquidation of a clearing FCM versus a non-clearing FCM). The Part 190 Subcommittee also built in flexibility to accommodate potential changes to the CFTC’s existing regulatory regime, should the CFTC decide to permit a DCO to clear trades for non-U.S. customers of foreign broker clearing members, or to permit a foreign clearing organization to clear swaps for customers of FCM clearing members pursuant to an exemption from DCO registration.

e. Definitions. The Model Part 190 Rules contain an updated and expanded set of definitions.

f. Claims Process in an FCM Proceeding. The Model Part 190 Rules contain updated, more flexible provisions for how the trustee may communicate with the failed FCM’s customers. They also include, in Appendix A, a streamlined proof of claim form that the trustee may (but is not required to) use.

7 g. Hedge Positions. The Model Part 190 Rules change the treatment of hedge accounts and positions. Currently, hedge positions are treated as a type of specifically identifiable property, in respect of which a customer has special rights to avoid having its positions liquidated by the trustee. Given the broader policy that the trustee should seek to port positions of public customers, and to mitigate the risk that having to spend time identifying hedge positions could impede prompt action by the trustee, the Part 190 Subcommittee instead recommends that the trustee may, when practical, treat a public customer’s hedge positions as specifically identifiable property. h. Collection of Margin and Variation Settlement. The Model Part 190 Rules update and clarify the trustee’s authority to collect margin and variation settlement from a failed FCM’s customers. The Part 190 Committee retained the important feature in the current rules that margin payments made by a customer in response to a trustee margin call are fully credited to the customer’s funded balance, and are thus not subject to pro rata distribution, because they count dollar-for-dollar towards the customer’s net equity claim. i. Deliveries. The Model Part 190 Rules provide much more detail on how the trustee for an FCM liquidation should handle open commodity contracts that settle by physical delivery, in the circumstances (which may be rare) when the failed FCM may be carrying contracts that are near or in a delivery position. The proposed rules are intended to accommodate the different ways in which deliveries could be accomplished, including updated provisions recognizing delivery of electronic title documents. The proposed delivery rules are broader than the current rules, in that they cover deliveries of financial commodities such as Treasury securities or foreign currencies, in addition to deliveries of physical (tangible) commodities. j. Delivery Account Class. The CFTC does not impose any customer funds segregation requirements on customer property that is held in a delivery account, which can make it more difficult to identify customer property in the delivery account class that is available for distribution, in particular customer property in the form of cash. Thus, the Part 190 Subcommittee recommends dividing the delivery account class into separate physical delivery and cash delivery account classes. k. Customer Property: The Griffin Trading Issue. The definition of customer property in current Rule 190.08(a) includes a provision that deems cash or other property in the debtor’s estate to be customer property, if and to the extent that customer property under other elements of the definition are insufficient to fully satisfy the claims of a failed FCM’s public customers. The provision, in effect, gives the FCM’s public customers a priority claim over other creditors to property in the bankruptcy estate to make up any shortfall that may exist in the relevant customer account class.

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The Bankruptcy Court in In re Griffin Trading20 ruled that the provision was invalid, finding that the CFTC exceeded its statutory authority in adopting the provision. The decision was vacated on appeal pursuant to a stipulation of the parties, and thus is not valid precedent, but it nonetheless spotlights a potential challenge that could be raised in other subchapter IV proceedings.

The Model Part 190 Rules retain the provision, but also include a more narrowly proscribed provision that reclassifies property in the debtor’s estate as customer property only to the extent that the FCM has failed to maintain a targeted residual amount of its own funds in segregation as required under CFTC Rule 1.11 or to meet its obligation to cover debit balances or under-margined amounts as required under CFTC Rules 1.22, 22.2 or 30.7. The Part 190 Subcommittee believes that this new provision is defensible because it is specifically linked to an FCM’s obligation to set aside property pursuant to Commission rule for the benefit of its customers, and thus should be covered by the definition of customer property in Section 761(10(A)(ix) of the Code.21

l. Separate Rules Governing a DCO Subchapter IV Proceeding. The Model Part 190 Rules include rules specific to a DCO proceeding, which are set out in Subpart C, to address the unique considerations that a DCO insolvency would raise. By design, the proposed rules are not overly prescriptive, to allow the trustee flexibility to respond appropriately to the specific circumstances it faces. The Part 190 Subcommittee recognizes that it may be unlikely that a DCO would be liquidated in a subchapter IV proceeding, but it believes that it is important to address that scenario, if there is any possibility that it could arise. The proposed Subpart C Rules may also provide guidance to the FDIC in the event it is administering the liquidation of a DCO in an orderly liquidation proceeding under Title II of Dodd-Frank, with respect to distribution of customer and member property in accordance with subchapter IV and in applying no creditor worse off standards.

3. Moving the Part 190 Project Forward. Should the Commission decide to move forward on the Part 190 Subcommittee’s proposal, the Commission would have to initiate a rulemaking proceeding to amend the existing Part 190 Rules. The Part 190 Subcommittee welcomes the opportunity to discuss the Model Part 190 Rules with Commission staff.

20 245 B.R. 291 (N.D. Ill. 2000), vacated, 270 B.R. 882 (2001). 21 This part of the definition covers “other property of the debtor that any applicable law, rule, or regulation requires to be set aside or held for the benefit of a customer.” 9