Kimberly D. Krawiec 0
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Kimberly D. Krawiec
In this special symposium issue, the Northwestern
JournalofInternationalLaw & Business tackles what promises to be one of the most
interesting and challenging legal fields of the 2 1st century: the regulation of
derivatives and other complex financial products. Interestingly, this field
experienced phenomenal growth and profound change during recent
decades, yet is virtually guaranteed to assume even greater importance in the
coming century and, accordingly, to present even greater challenges for
investors, market professionals, and regulators.
Contrary to common belief, the use of derivatives to hedge against or
speculate on price changes in assorted variables is not a new phenomenon.
In fact, historians have discovered derivatives use as early as 2000 B.C.' In
the United States, the state of Massachusetts Bay in the 1700's and the
Confederacy in the course of financing the Civil War each issued what would
today be termed "structured notes," that is, debt instruments whose payout
streams are tied to an underlying reference rate, asset, or index.2 By the
middle part of the eihteenth century, a fully operational futures market was
ongoing in Chicago.
It was not until recent decades, however, that growth in the derivatives
markets exploded, due primarily to important advances in communications
and technology, the globalization of commercial and financial markets, and
1Jerry W. Markham, "ConfederateBonds," "General Custer," and the Regulation of
DerivativeFinancialInstruments,25 SEToNHALL L. Rnv. 1, 1 (1994).
2Id. (describing some early instances of derivatives use).
the search by market participants for higher yields and lower funding costs.4
For at least the past decade, derivative instruments have comprised one of
the world's fastest growing financial markets. By the middle of 2000, for
example, the estimated notional amount of outstanding derivatives contracts
exceeded $105 trillion,5 more than four times the $24.6 trillion outstanding
at the 6end of 1992 (an amount which itself seemed staggeringly large at the
This growth has shown no signs of abating, meaning that the topics
addressed by these symposium authors are not only timely, but also
extraordinarily important. As recognized by the symposium authors, the derivatives
markets of the twenty-first century are likely to pose new variations on old
challenges, rather than to piresent radically new problems.
For example, all followers of major derivatives events will easily recall
the large investor losses of the 1990's: Orange County, California; Barings
PLC; Procter & Gamble; and Metallgesellschaft, to name just a few. This
spate of losses among wealthy, seemingly sophisticated investors led many
commentators to question whether sellers of derivative products should owe
some level of fiduciary duty to their customers, even when the customer is a
"sophisticated" investor such as these. 7
In her contribution to this symposium, Helen Parry revisits the issue of
derivatives losses by wealthy investors through an examination of the
protections (or lack thereof) afforded to hedge fund investors.' While noting
that regulators have traditionally rightly focused their protective efforts on
investors considered unable to fend for themselves, she also notes that in
today's bear market, more investors are being drawn into riskier and more
leveraged investments in the search for higher profits.9 She further notes
that the "new rich" - for example, sports and media stars and dot-comers
who have large asset bases but relatively little investment experience, are
particularly susceptible to aggressive or manipulative sales tactics.10 She
advocates a regulatory regime that classifies investors (and the level of
protection they are entitled to) based on a real assessment of investment
expertise, and not on investor wealth."
United States securities law generally rejects attempts to classify
investors based on real tests of sophistication or experience, and instead uses
investor income as a proxy for determining investor sophistication. In fact,
the perceived uncertainties inherent in the Ralston Purinacase-by-case test
of investor sophistication motivated the Securities and Exchange
Commission ("SEC") to adopt income thresholds as a test for investor accreditation
in Regulation D of the Securities Act of 1933.12 The Commodity Futures
Modernization Act of 2000 ("CFMA") follows this basic approach, by
defining "Eligible Contract Participant" to include individuals with assets in
excess of $10 million, thus assuming some level of investment
sophistication among wealthy individuals. 3
Nonetheless, issues regarding how losses should be allocated between
sellers and buyers when a derivatives transaction goes wrong are likely to
remain prominent throughout the coming years. This is likely to be
particularly true as increasing numbers of individual investors, some of
comparatively modest means, enter the derivatives markets, often through hedge
funds, which are capitalizing on attempts by individual investors to
outperform the recent lackluster stock market by accepting increasingly small
investment stakes, 14 and through single stock futures (scheduled to begin
trading in the United States on December 21, 2001.)15
As discussed by Frank Partnoy in his contribuition to this symposium,
the introduction of trading in single-stock futures - banned in the United
States since the 1982 Shad-Johnson Accord - promises to pose challenges
to regulators, the exchanges, and investors for many years to come 6 As
Partnoy explains, the introduction of single-stock futures trading in the
United States raises a host of unresolved issues, including margin
12 In SEC v. Ralston Purina Co., 346 U.S. 119 (1953), the Court stated that an offering to
persons "able to fend for themselves" was not a public offering. Ex-ante determinations of
which investors were sophisticated enough to fend for themselves proved difficult in
practice, however. The SEC granted some relief through the Regulation D safe-harbor, which
defines "accredited investor" in terms of income thresholds, rather than sophistication tests.
See Reg. D, Rule 501(a).
13This amount is reduced to $5 million if the individual is managing the risk of an asset
owned or liability incurred (or reasonably likely to be incurred).
14Gregory Zuckerman, Hedge Funds Find Room for Little Guys -- Brokers Chaperone
Small investors,WALL ST. J., Cl (August 1, 2000) (noting that the "small stakes" hedge fund
sector - which accepts individual investments of $100,000 - is one of the fastest growing
Wall Street sectors.)
ISThe Commodity Futures Modernization Act of 2000, § 202(a)(5), available at 114
STAT 2763 (2000).
16 See Frank Partnoy, MultinationalRegulatory Competition and Single-Stock Futures,
21 Nw. J. INT'L. L. & Bus. 641 (2001) (discussing several implications of the single-stock
ments, the use of single-stock futures to commit securities fraud and insider
trading, and the use of single-stock futures to take short positions more
cheaply and effectively than currently possible through short sales of
In his contribution to this symposium, William J. Brodsky also
discusses the CFMA's repeal of the ban on single-stock futures, by discussing
how political infighting between the SEC and the Commodity Futures
Trading Commission ("CFTC") gave rise to the ban to begin with, and arguing
that the multi-regulator system of derivatives supervision in the United
States - with power shared between the SEC and the CFTC - is
inefficient and outdated, and should be eliminated in favor of a single regulator
As Brodsky explains, United States derivatives regulation can only be
understood through historical analysis.1 9 Specifically, derivatives
regulation in this country originated as agricultural regulation - a system that is
ill equipped to manage the huge and quickly growing financial derivatives
markets of today.
Federal regulation of derivatives markets in the United States began
with the Future Trading Act of 192120, an act pushed by farmers and their
congressional representatives in an attempt to gain greater control over
grain price setting from the grain middlemen (elevator operators, grain
dealers, and the like). Originally, the farmers' lobby advocated a complete
ban on grain futures, or at least on grain futures speculation, by requiring an
existing cash position. In the end, however, they settled for a prohibitive
tax on grain futures not undertaken on an authorized exchange (termed a
"board of trade"). 22 Authority for approving boards of trade was granted to
the Secretary of Agriculture.
With the Commodity Exchange Act of 1936,23 the authority of the
Secretary of Agriculture was expanded to include broker licensing and
speculative position limits. In addition, jurisdictional authority was extended to
18 William J. Brodsky, New LegislationPermittingStock Futures: The Long and Winding
Road, 21 Nw. J. INT.'L. L. & BUS. 573 (2001).
19For excellent discussions of the history of derivatives regulation in the United States
see Roberta Romano, The PoliticalDynamics of Derivative SecuritiesRegulation, 14 YALE
J. REG. 279 (1997), and Jerry W. Markham, THE HISTORY OF COMMODITY FUTURES TRADING
AND20ITFSuRtuErGeUTLrAadTiInOgN A(1c9t8,74)2. Stat. 187 (1921).
21 Romano, supranote 19.
22 The Supreme Court struck down the Future Trading Act as an unconstitutional exercise
of Congress's taxing power. Hill v. Wallace, 259 U.S. 44 (1922). Congress immediately
reenacted the statute as the Grain Futures Act of 1922 under its Commerce Clause powers. 42
Stat. 998 (1922). See Romano, supranote 19 at n.10.
23 Pub. L. No. 74-675, 49 Stat. 1491 (codified at 7 U.S.C. §§ 1-15 (1994)).
cover commodities other than grains, including, cotton, butter and eggs.24
These changes, however, did not alter the basic structure of derivatives
regulation as an agricultural regulatory regime, designed primarily to
address the needs of farmers and other members of the farming industry. This
made sense at the time, as the derivatives markets were primarily
agricultural in character and were used primarily by the farm industry to hedge
agricultural product prices.
It was not until the Commodity Futures Trading Commission Act of
1974 that derivatives regulation first moved beyond its agricultural roots.25
With the 1974 Act, Congress transferred regulation of futures markets from
the Secretary of Agriculture to an independent agency - the CFTC. Part
of the impetus behind the 1974 Act was the perceived need to address the
regulation of non-agricultural commodities, such as metals and foreign
currency. Accordingly, the new CFTC was given regulatory jurisdiction (with
a few relatively narrow exceptions) over all futures contracts (other than
transactions in foreign currency not conducted on a board of trade), and the
SEC retained its then-current jurisdiction - stock and stock options.2 6
Although this division of power was not seen as problematic at the
time (after all, there were no stock futures yet in existence) it set the stage
for Mr. Brodsky's criticisms over 25 years later, by creating a system of
dispersed United States financial market regulation. Of course, the
problems attendant in such a dispersed system were unforeseen at the time,
because no one could predict the drastic changes that were about to take place
in the derivatives markets.
Those changes emerged only one year later, however, when in 1975
the Chicago Board of Trade ("CBOT") introduced the first financial futures
contract: a contract on Ginnie Mae pass-through certificates. 27 This
contract assumes extraordinary historical importance for two reasons. First, the
SEC (which regulated the underlying certificates) unsuccessfully opposed
trading in the contract, thus beginning a long-standing turf battle between
the SEC and the CFTC. Second, it marked the beginning of a permanent
24 Romano, supranote 19.
2 Pub. L. No. 93-463, 88 Stat. 1389 (codified as amended at 7 U.S.C. §
4(a) et seq.
26rhe definition of commodity was expanded to include nearly every agricultural
commodity, except onions, as well as "all other goods and articles ... and all services, rights, and
interests in which contracts for future delivery are presently or in the future dealt in." 7
U.S.C. § la(3).
The provision exempting foreign currency from the CFTC's jurisdiction is known as the
"Treasury Amendment," so named because it was added to the bill at the request of the
Treasury Department. By 1974, federally chartered and supervised banks had an active
foreign exchange business, which they did not want disturbed by CFTC regulation. See
Romano, supra note 19.
27 For discussions of the Ginnie Mae contract battle see Romano, supranote 19; Brodsky,
supra note 18.
change in the character of the derivatives markets: from primarily
agricultural, to primarily financial.
Given its failure to prevent the CFTC exchanges from trading in
financial futures, the SEC shifted course in 1981 and authorized one of its
regulated exchanges, the Chicago Board Options Exchange ("CBOE"), to begin
trading Ginnie Mae options. Although the CBOT successfully sued in the
Seventh Circuit to prevent the CBOE contracts, the SEC and CFTC reached
an agreement in order to avoid protracted and expensive future litigation. 8
This agreement gave rise to the 1982 Shad-Johnson Accord (named after
the then-current SEC and CFTC chairmen), which prohibited futures on all
individual stocks and non-exempt bonds. 29 The Accord preserved the
CFTC's jurisdiction over all futures, but required consultation between the
SEC and the CFTC regarding the approval of stock index futures. Finally,
the Accord granted the SEC veto power over stock index futures and
options on such futures that were not broadly based.
The problems and limitations of the Accord became evident almost
immediately.30 "Hybrid securities" that were not explicitly covered by the
Accord quickly developed, generating legal uncertainty as to their treatment
under the commodities and securities laws. The over-the-counter ("OTC")
derivatives markets began exponential growth, yet uncertainty as to whether
such products might be deemed illegal off-exchange futures arguably
hampered the development of the market, and fears that the entire market would
move offshore to avoid its uncertain legal status in the United States were
frequently present. Finally, both the SEC and the New York Stock
Excehxaacnegrebdatbinlagmtehde 1d9if8f7icsutloticeks minarckoeotrcdriansahti.n31g multiple regulatory efforts for
Although the CFMA addressed some of these issues, by permitting
single-stock futures, subject to CFTC and SEC regulation, and by
address28 CBOT v. SEC, 677 F.2d 1137 (7h Cir.) vacated as moot, 459 U.S. 1026 (1982).
29 The fight over stock futures basically centered around the CFTC's insistence that it had
jurisdiction over all futures, including stock futures. The SEC, however, fought the CFTC's
attempts to regulate stock futures, claiming that the CEA and CFTC rules did not address
issues such as market manipulation, insider trading, suitability, and margin requirements in the
same manner as did the securities laws and SEC rules. Accordingly, the SEC expressed
some well-founded concerns that the lighter regulation of stock futures could destabilize the
underlying securities markets and undermine the SEC's efforts to promote market integrity
in that area. Unable to reach an agreement, both sides determined to ban single stock futures
outright, and to conduct a study regarding the issue. That study was never conducted. See
Brodsky, supra note 18 at 3.
30 For more detailed discussions of these problems see Romano, supra note 19; Brodsky,
supra note 18.
31 As Romano notes, such criticisms, though plausible, were also self-serving. If the
CFTC's jurisdiction over stock index futures could be blamed for exacerbating the crash,
then the SEC's political position would be strengthened when it attempted to wrest control of
stock futures from the CFTC during the upcoming CFTC reauthorization hearings. Romano,
supra note 19.
ing many of the legal uncertainties surrounding hybrids and OTC
derivatives, it left the basic structure of the old system - first developed in the
1920's and 1930's when separate regulation of the securities and
derivatives markets made sense because those markets rarely if ever overlapped
- intact. Like Mr. Brodsky, many other commentators - including
former President George Bush, Sr. - have urged Congress to merge the
CFTC and SEC into a single regulator. As Mr. Brodsky notes, however,
political forces, including oversight of the CFTC and the SEC by separate
congressional committees (agriculture and commerce, respectively), each
unwilling to cede power to the other, has sustained the current, highly
imperfect system, and is likely to do so for some time to come.
sustaining the U.S. system ofmultiple f'mancial regulators).
4 U.S. General Accounting Office, No. 94 - 133 , Financial Derivatives: Actions Needed to Protect the Financial System 3 ( 1994 ), availableat 1994 WL 2476176-77.
5 Press Release, Bank of International Settlements, The Global OTC DerivativesMarket Continuesto Grow (Nov. 13 , 2000 ), availableat http://www.bis.orglpress/pO0113.htm.
6 Jacob M. Schlesinger , Money- Go-Round: Why the Long Boom? It Owes a Big Debt To the CapitalMarkets, WALL ST . J. Al (February 1 , 2000 ) (quoting Swaps Monitor) .
7 See, e.g., Donald C. Langevoort , Selling Hope, Selling Risk: Some Lessons for Law from Behavioral Economics about Stockbrokers and SophisticatedCustomers, 84 CAL. L. REv. 627 ( 1996 ) (advocating "meaningful risk disclosure requirements," even for sophisticated investors ).
8 Helen Parry , Hedge Funds, Hot Markets and the High Net Worth Investor: A Casefor GreaterProtection?,21 Nw . J. INrr'L. L . & Bus . 703 ( 2001 ).