Legal Challenge to Position Rules Mounted

Terry Flanagan

Industry groups say that CFTC rulemaking process is fundamentally flawed.

Long simmering tensions over the Commodity Futures Trading Commission’s position limits rule have reached a flashpoint with the filing of a lawsuit challenging the rule by the International Swaps and Derivatives Association (ISDA) and the Securities Industry and Financial Markets Association (Sifma).

The legal challenge asserts that that the position limits rule may adversely impact commodities markets and market participants, including end-users, by reducing liquidity and increasing price volatility.

In addition, the Associations contend that the CFTC’s decision-making process in enacting the rule was procedurally flawed.

Among other deficiencies, the CFTC adopted the Rule without making findings as to the necessity and appropriateness of the position limits, as required by statute, the suit alleges.  Furthermore, the CFTC failed to conduct any meaningful cost-benefit analysis and lacked a reasoned basis for its rule, according to the lawsuit.

The legal challenge is the first to arise from the Dodd-Frank rulemaking process, and follows similar challenges to other rulemakings under securities laws.

“Although this is the first lawsuit against the CFTC in its history, rule challenge lawsuits are not unprecedented,” Patricia Rogers, co-chair of the financial institutions group at Moye White, told Markets Media.  “The SEC had its first rule under Dodd-Frank overturned by a federal court of appeals in July.”

Kenneth Raisler, partner in the commodities derivatives practice at Sullivan & Cromwell, told Markets Media, “This follows the SEC proxy access rules that the court overturned.  Indeed this is the same law firm that represented the Chamber of Commerce the plaintiff in that lawsuit.”

The CFTC’s interim final rule on position limits, which was published on Nov. 18 and is due to take effect next year, is contingent on the CFTC’s definition of the term “swap” under the Dodd-Frank Act.

The derivatives industry has attacked the rule through comment letters, and the CFTC has given ground on some issues.

For example, it backed off on a proposal that would have set conditional spot-month limits on derivatives contracts.

A proposed rule issued by the CFTC in January set spot-month position limits at 25 percent of deliverable supply for a given commodity, with a conditional spot-month limit of five times that amount for entities with positions “exclusively” in cash-settled contracts.

But in its interim final rule, the CFTC dropped the requirement that positions be exclusively in cash-settled contracts.

The agency said it agreed with comments it received urging it to gain further experience with swaps to ensure adequate liquidity for bona fide hedging transactions and positions before imposing restrictive conditions on people holding both cash-settled and physical delivery referenced contracts.

Spot-month position limits will apply separately to physically-settled and cash-settled contracts: a trader may hold positions during the spot-month in physically-settled contracts in an amount up to the spot-month limit (which is set at 25% of deliverable supply), and may separately hold positions in cash-settled contracts up to that limit.

A carve-out has been created for natural gas contracts that reference physically-settled natural gas contracts (Nymex Henry Hub Natural Gas Referenced Contracts).

While the physically-settled spot-month limit for natural gas contracts is set at 25% of deliverable supply, natural gas contracts are subject to a more permissive conditional limit for cash-settled contracts, which is equal to five times the physically-settled limit.

Another issue for dealers is the final rule’s provisions on aggregation of accounts and positions.

The proposed rules would have eliminated the Independent account Controller (IAC) exemption and restricted existing disaggregation provisions. In response to comments, however, the CFTC decided to retain the IAC exemption.

The IAC exemption preserved by the final rule permits disaggregation between proprietary positions and those managed on behalf of clients; the IAC exemption, however, does not permit proprietary positions to be disaggregated from other proprietary positions.

The lawsuit wasn’t a surprise, given that many trade groups have been threatening legal action over the past year. “Many people commented, long before the lawsuit was filed, that the cost-benefit analysis was weak and unsupported,” Rogers said. “It will be interesting to see where the expert testimony (and court, ultimately) comes out on this one. If the trade groups win, it may change the way rulemaking is done within the CFTC and other agencies going forward.”

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