The CFTC recently approved a futures contract on a dividend index as a non-security based index futures contract over the SEC’s objection that the dividend index contract could be a security future; the CFTC’s actions may have implications for market participants in this and other dividend index futures contracts and swaps.
On July 22, the US Commodity Futures Trading Commission (CFTC) issued a conditional order approving a proposed listing by the Chicago Mercantile Exchange (CME) of a futures contract (Index Contract) on the S&P 500 Dividend Index (Dividend Index). In approving the listing of the Index Contract as a futures contract, the CFTC determined that the Dividend Index is not a security-based index, but rather an “excluded commodity” subject to the CFTC’s exclusive jurisdiction. The CFTC made this determination notwithstanding a comment letter filed by the staff of the US Securities and Exchange Commission (SEC) raising “substantial” legal and policy concerns over whether the product should be instead categorized as a security future subject to the joint jurisdiction of both agencies.
As explained below, while the CFTC’s action may clarify its position with respect to dividend index products, the fact that it acted without the concurrence of the SEC could have implications for a variety of market participants that wish to trade in dividend index futures or swaps.
As explained in the CFTC Order, the Dividend Index represents the accrued ex-dividend amounts associated with all the component companies of the S&P 500 cumulated over the course of a specific quarterly accrual period. At any given point, the Dividend Index represents a running total of dividends, through their ex-dividend dates, associated with all the stocks in the S&P 500. The Dividend Index is calculated through a bottom-up approach whereby a running total of the dividends paid by the component companies during the quarter is continuously calculated. The cumulative dividends for the S&P 500 are then converted into index points, which represent the dividend index levels. The issue in contention between the CFTC and the SEC is whether the Dividend Index is a security future (and in particular, a narrow-based security index as defined by the amendments to the federal securities and commodities laws made by the Commodity Futures Modernization Act of 2000 (CFMA)) or a non-security based index futures contract. Under the CFMA, the SEC and CFTC have joint jurisdiction over security futures products. The effect of the CFTC Order is to exclude the SEC from having the oversight role over the Dividend Index that it would otherwise have if the Index Contract was considered a security future.
REGULATION OF SECURITY FUTURES
The CFMA eliminated a long-standing prohibition against the trading of security futures products by US investors and gave the SEC and the CFTC joint jurisdiction over such products. The Securities Exchange Act of 1934 (Exchange Act) and the Commodity Exchange Act (CEA) each define a “security future”  to mean, in relevant part, “a contract of sale for future delivery of a single security or of a narrow-based security index, including any interest therein or based on the value thereof.”  Because a security future is both a security and a future, securities exchanges and boards of trades that list and trade security futures products, and persons that facilitate transactions in security future products, are subject to the joint jurisdiction of the CFTC and the SEC.
Of particular relevance in connection with the Index Contract are the changes that the CFMA made to the statutes under the SEC’s jurisdiction. The CFMA added Section 6(h) to the Exchange Act which, among other things, (1) makes it unlawful for any person to effect transactions in security futures products that are not listed on a national securities exchange or a national securities association registered under Section 15A(a) of the Exchange Act;  and (2) generally requires that security futures products conform with listing standards that are filed with the SEC and that meet criteria specified in Section 2(a)(1)(D)(i) of the CEA. In addition, the CFMA added Section 3(a)(14) of the Securities Act, which exempts security futures products from the requirements of that Act, including Section 5, which generally requires that securities be registered with the SEC to be sold. This exemption, however, is conditioned on the security future product being (i) cleared by a clearing agency registered under Section 17A of the Exchange Act or exempt from registration under Exchange Act Section 17A(b)(7) and (ii) traded on a national securities exchange or a registered national securities association.
CFTC ORDER AND SEC OBJECTIONS
In approving the Index Contract under Section 5c(c)(4) of the CEA, the CFTC stated that the Dividend Index is an excluded commodity as defined in Section 1a(19) of CEA because it is an “economic or commercial index based on . . . values or levels that are not within the control of any party to the relevant contract, agreement or transaction,” or, in the alternative, is an “occurrence, extent of an occurrence, or contingency . . . that is beyond the control of the parties to the relevant contract, agreement, or transaction and is associated with a financial, commercial, or economic consequence.” Based on this reasoning, the CFTC took the position that the Dividend Index is not a security or security index and is under its exclusive jurisdiction.
In its comment letter to the CFTC regarding the Index Contract, the SEC stated that there was a reasonable basis for taking the view that the Index Contract is a security future subject to the joint jurisdiction of the agencies. The SEC stated that, because the definition of a security future is contained in statutes that are separately administered by the CFTC and the SEC, neither agency has a final say on whether a product is a security future. The SEC Letter then alluded to discussions between the staff of both agencies on how to analyze whether a future on a dividend index would be viewed as a narrow-based security index and thus a security future under the joint jurisdiction of both agencies. In support of its view that the Index Contract should be under the jurisdiction of both agencies, the SEC highlighted that the definition of a security future includes the concept of “any interest therein or based on the value thereof” relating to a security or a narrow-based index of securities. The SEC then cited to a 2009 order under which it stated that “‘[t]he concept of an ‘interest therein’ in a security plainly includes rights generating a pecuniary interest in a security, such as the right to a dividend payout or bond (coupon) payment.’” The SEC Letter goes on to state that the 2009 SEC Order found that “options on the value of dividends declared by issuers of component securities of a group or index of securities are options on an interest in, or based on the value of an interest in, that group or index of securities.” The SEC Letter then stated that the Index Contract could be viewed as satisfying all of the components in the definition of a narrow-based security index, and that there is a reasonable basis for taking the view that the Index Contract is a security future. It is worth highlighting, however, that while the SEC Letter takes a particularly forceful position, it was sent by the staff and not the SEC as an administrative body. While the SEC, as an administrative body, could take a different view than that expressed by the staff, it is unlikely that the various SEC commissioners were not aware that the staff would be sending the letter. Notably (and consistent with the position taken in the CFTC Order), CFTC staff submitted a comment letter to the SEC in connection with the 2009 SEC Order where it argued, among other things, that the Dividend Index was more akin to an event contract rather than a securities index.
The CFTC’s decision to approve the Index Contract over the SEC staff’s objections will raise a number of uncertainties for market participants, as well as raising questions as to the SEC’s authority over security-based swaps.
As an initial matter, because the SEC staff may view futures contracts on dividend indexes as security futures, the SEC may potentially view the listing of such contracts by a Futures Exchange that is not notice registered with the SEC as a violation of Section 6 of the Exchange Act, which requires securities exchanges to register with the SEC. Further, to the extent that persons transact in security futures products on a Futures Exchange that is not also registered with the SEC as a securities exchange (whether fully or through the notice provisions of Exchange Act Section 6(g)), such persons could potentially face liability under Section 6(h)(1) of the Exchange Act. As mentioned above, that section makes it unlawful for any person to transact in security futures products unless such products are traded on a national securities exchange or national securities association. In addition to liability under Exchange Act Section 6(h)(1), persons that transact in futures contracts on dividend indexes that the SEC deems to be security futures could also face liability under Section 5 of the Securities Act because the exemption from registration for security future products only extends to those that are traded on a securities exchange or securities association. Additionally, FCMs that are not registered as broker-dealers with the SEC (whether fully or through the notice provisions) could face liability for acting as unregistered broker-dealers when effecting transactions in such products if the SEC took the view that the Index Contracts should be regulated as security futures.
Although the CME is notice-registered as a securities exchange, it is possible that the SEC could argue that the listing of the Index Contract would violate Exchange Act Section 6(h)(2) (which requires that security futures products conform to listing standards as approved by the SEC). Further, the SEC could also take the aggressive view that the CME’s notice registration as a securities exchange is ineffective as to the Index Contract.
The views expressed in the CFTC Order also have implications for the jurisdictional allocation between the CFTC and SEC over swaps and security-based swaps. Title VII of the Dodd-Frank Act (Title VII) created a comprehensive framework for the regulation of swaps and security-based swaps. Among other things, Title VII created a split approach to the treatment of swaps and security-based swaps, giving the CFTC jurisdiction over swaps and the SEC jurisdiction over security-based swaps. A security-based swap is defined in Section 3(a)(68) of the Exchange Act as any agreement, contract, or transactions that is as a swap (as defined in Section 1a(47) of the CEA) and is based on, in relevant part, “an index that is a narrow-based security index, including an interest therein or on the value thereof” (emphasis added). Although the CFTC and the SEC provided additional guidance in 2012 regarding the definitions of swap and security-based swap, as well as the meaning of a narrow-based security index, they did not specifically address dividend indices. To the extent that the CFTC applies its views regarding dividend indices to swaps, there will be implications regarding the regulatory status of swaps on dividend indexes, and whether such swaps are CFTC regulated swaps or are SEC regulated securities based swaps. Thus, concerns over regulatory uncertainty similar to those for Future Exchange, intermediaries, and market participants in the context of the Index Contracts are also present for swaps markets, swaps intermediaries, and swap market participants in the context of swaps on a Dividend Index.
Finally, the CFTC position has potential implications for registered investment companies (RICs) under the 1940 Act because the definition of a “security” under Section 2(a)(36) of that Act includes a “security future,” and the CFTC is now characterizing at least some dividend indices as not being security-based indices (and therefore not security futures, and thus not securities). It is unclear whether the CFTC’s position regarding dividend indices will give rise to tax issues for RICs under Subchapter M of the Internal Revenue Code. In this regard, RICs may want to consult with experienced 1940 Act counsel and tax counsel when transacting in particular Dividend Index products.
While the courts (or Congress) may ultimately have to decide whether the Index Contract and other futures contracts on a dividend index is a security future, in the interim, market participants need to weigh the degree of comfort from and level of regulatory uncertainty surrounding the CFTC Order and its implications. Until there is greater clarity on the SEC’s potential actions with respect to the Index Contract and other dividend index contracts, market participants may want to exercise caution when entering into futures contracts on dividend indexes or entering into swap contracts on such products.