Most derivatives and capital market lawyers usually spend more time worrying about the price of avocados than Constitutional law issues. Hungry lawyers now have reason to be concerned about the rights of derivatives market participants under the 4th and 5th Amendment under the U.S. Constitution. The 4th Amendment prohibits unreasonable searches and seizures by governmental agencies. The 5th Amendment, among other things, affords due process of law which requires notice and an opportunity to be heard. Because of the 4th and 5th Amendment protections, government agencies generally must seek a subpoena issued by a court before they can search or seize property. The Commodity Futures Trading Commission (CFTC) has proposed a new rule that could require traders to hand over their intellectual property (IP) to the government without a subpoena.
On December 17, 2015, the CFTC published a notice of proposed rulemaking (NPRM) to improve regulation of automated trading of listed derivatives on designated contract markets (DCMs) (collectively, Reg AT). The NPRM for Reg AT includes a number of important risk controls and other safeguards intended to enhance the safety and soundness of electronic derivatives trading. The NPRM also proposes that traders must create a source code repository for its trading algorithms in accordance with the CFTC’s basic recordkeeping requirements under Regulation 1.31. This raises Constitutional issues because, under the NPRM, the CFTC would not be required to obtain a subpoena to inspect a trader’s source code.
A trader’s source code is best defined as a collection of computer instructions as they are originally written (i.e., typed into a computer) in plain text (i.e., human readable alphanumeric characters) comprising executable software capable of exercising discretion over an order on the production environment of a DCM without human intervention. In this context, discretion means the ability to (i) submit, modify, or cancel the order and (ii) determine and set the relevant order details submitted to the DCM. Source code is a trader’s valuable IP that forms the basis of a trader’s present and future trading strategies. Public disclosure of a trader’s IP could result in a substantial economic loss. Forced disclosure of IP should not be taken lightly. Given the Constitutional law issues and potential risks created by disclosing source code, the CFTC sought further comment on its NPRM for Reg AT.
On November 4, 2016, the CFTC published a Supplemental Notice of NPRM on Reg AT (Supplemental Notice) to address comments received from market participants. The CFTC’s Supplemental Notice acknowledged concerns over source code disclosure and proposed additional limits to the CFTC’s access to a trader’s source code. Under the Supplemental Notice, the CFTC could only gain access to a trader’s source only via a subpoena or through a new CFTC “special call”. The Supplemental Notice doesn’t provide much detail on the “probable cause” required by the CFTC to approve a special call or for traders to be afforded notice or an opportunity to be heard. The Supplemental Notice does require the CFTC to maintain in confidence any records turned over to the CFTC pursuant to a special call. The records protected under a special call include data and information that would separately disclose the market positions, business transactions, trade secrets or names of customers of any person. Unfortunately, the CFTC’s technical ability to maintain the data privacy of a trader’s source code or other records is uncertain.
The CFTC’s disregard for the Constitutional issues triggered proposed Reg AT is troubling. No other governmental agencies can require market participants to disclose IP without a subpoena or similar judicial process. If a farmer developed a genetically modified avocado that’s always ripe and never turns brown when made into guacamole, the Food & Drug Administration can’t require the farmer to turn over the IP behind a genetically engineered avocado. The genetic code for the super-avocado is the farmer’s IP, and although it may sound like a silly example, the issues at stake are serious. Under Reg AT, as currently proposed, the CFTC could have access to IP that no other government regulator currently has. More crucially, the NPRM and Supplemental Notice for Reg AT jeopardize fundamental rights under the 4th and 5th Amendments because the proposed rules don’t provide market participants with due process. Regardless of whether the government seeks IP related to avocados or source code, derivatives lawyers should consider the Constitutional issues at stake and prevent the CFTC from demanding that traders hand over their IP or other property without a subpoena.