Trade Options on the Enumerated Agricultural Commodities

COMMODITY FUTURES TRADING COMMISSION

17 CFR Parts 3, 32 and 33

Trade Options on the Enumerated Agricultural Commodities

AGENCY: Commodity Futures Trading Commission.

ACTION: Interim final rules.

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SUMMARY: Generally, the offer or sale of commodity options is

prohibited except on designated contract markets. 17 CFR 32.11. One of

several specified exceptions to the general prohibition on off-exchange

options is for ``trade options.'' Trade options are off-exchange

options ``offered by a person having a reasonable basis to believe that

the option is offered to'' a person or entity within the categories of

commercial users specified in the rule, where such commercial user ``is

offered or enters into the transaction solely for purposes related to

its business as such.'' 17 CFR 32.4(a). Trade options, however, are not

permitted on the agricultural commodities which are enumerated in the

Commodity Exchange Act (Act). 7 U.S.C. 1a(3).

The Commodity Futures Trading Commission (Commission or CFTC) is

removing the prohibition on off-exchange trade options on the

enumerated agricultural commodities pursuant to a three-year pilot

program. Because it intends to reexamine these rules during and at the

conclusion of the pilot program, these rules are being promulgated as

interim final rule (interim rules). The interim rules, like the

proposed rules, permit only agricultural trade options which, if

exercised, will result in delivery of the commodity. Such options may

not be resold, repurchased, or otherwise cancelled other than through

the exercise or natural expiration of the contract.

Also, the interim rules permit only those entities which handle the

commodity in normal cash market channels to solicit, to offer to buy or

sell, or to buy or sell such options. Vendors of such options would be

required to become registered as agricultural trade option merchants,

to report to the Commission on their transactions, to provide their

customers with disclosure statements, and to safeguard their customers'

premiums. The interim rules substantially streamline requirements

contained in the proposed rules, particularly the proposed

registration, reporting rules, particularly the proposed registration,

reporting and customer fund segregation requirements. The Commission is

exempting from the prohibition and these interim rules individuals or

entities which meet a substantial financial requirement, as it

proposed. Finally, the Commission is removing the prohibition on the

offer or sale of exchange-traded options on physicals on these

commodities.

CFTC will publish at a late time a document in the Federal Register

requesting comments on these interim rules.

EFFECTIVE DATE: June 15, 1998.

FOR FURTHER INFORMATION CONTACT: Paul M. Architzel, Chief Counsel,

Division of Economic Analysis, Commodity Futures Trading Commission,

Three Lafayette Centre, 1155 21st Street, N.W., Washington, D.C. 20581,

(202) 418-5260, or electronically at [PA[email protected]].

SUPPLEMENTARY INFORMATION:

I. Background

A. The Prohibition of Agricultural Trade Options

In 1936, responding to a history of large price movements and

disruptions in the futures markets attributed to speculative trading in

options, Congress completely prohibited the offer or sale of option

contracts both on and off exchange in the specific list of agricultural

commodities then under regulation.\1\ Any commodity not so enumerated

was unaffected by the prohibition.

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\1\ The specific agricultural commodities originally regulated

under the 1936 Act included, among others, grains, cotton, butter,

eggs, and potatoes. Later, fats and oils, soybeans and livestock, as

well as others, were added to the list of enumerated agricultural

commodities. Commodity Exchange Act of 1936, Public Law No. 74-675,

49 Stat. 1491 (1936). See, H. Rep. No. 421, 74th Cong., 1st Sess. 1,

2 (1934); H. Rep. No. 1551, 72d Cong., 1st Sess. 3 (1932). A more

complete statement of the statutory and regulatory history of the

ban is provided in the Notice of Proposed Rulemaking, 62 FR 59624

(November 4, 1997).

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A history of abusive practices and fraud in the offer and sale of

off-exchange options in the non-enumerated commodities was one of the

catalysts leading to enactment of the Commodity Futures Trading

Commission Act of 1974 (1974 Act). The 1974 Act created the Commission,

substantially strengthen the Commodity Exchange Act and broadened its

scope by bringing all commodities under regulation for the first time.

The newly-created CFTC, vested with plenary authority to regulate the

offer and sale of commodity options,\2\ promulgated a comprehensive

regulatory framework applicable to off-exchange commodity option

transactions in the non-enumerated commodities.\3\ This comprehensive

framework exempted ``trade options'' from most of its provisions except

for a rule prohibiting fraud (rule 32.9).\4\ In contrast, the

prohibition on the offer and sale of all options on the enumerated

agricultural commodities remained as a consequence of both statutory

provision and Commission rule. See, 17 CFR 32.2.

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\2\ Section 4c(b) of the Act provides that no person ``shall

offer to enter into, or confirm the execution of, any transaction

involving any commodity regulated under this Act'' which is in the

nature of an option ``contrary to any rule, regulation, or other of

the Commission prohibiting any such transaction or allowing any such

transaction under such terms and conditions as the Commission shall

prescribe.'' 7 U.S.C. 6c(b).

\3\ 17 CFR part 32. See 41 FR 51808 (Nov. 24, 1976) (Adoption of

Rules Concerning Regulation and Fraud in Connection with Commodity

Option Transactions). See also, 41 FR 7774 (February 20, 1976)

(Notice of Proposed Rules on Regulation of Commodity Option

Transactions); 41 FR 44560 (October 8, 1976) (Notice of Proposed

Regulation of Commodity Options).

\4\ As noted above, trade options are defined as off-exchange

options ``offered by a person having a reasonable basis to believe

that the option is offered to the categories of commercial users

specified in the rule, where such commercial user is offered or

enters into the transaction solely for purposes related to its

business as such.'' 41 FR at 51815; rule 32.4(a) (1976). This

exemption was promulgated based upon an understanding that

commercial users of the underlying commodity has sufficient

information concerning commodity markets insofar as transactions

related to their business as such, so that application of the full

range of regulatory requirements was unnecessary for business-

related transactions in options on the non-enumerated commodities.

See 41 FR 44563, ``Report of the Advisory Committee on Definition

and Regulation of Market Instruments,'' appendix A-4, p. 7 (January

22, 1976).

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However, the attempt to create a regulatory framework to govern the

offer and sale of off-exchange commodity options was unsuccessful and

was suspended.\5\ In 1982, based on the separate, successful pilot

program to introduce exchange-traded options on the non-enumerated

commodities, Congress eliminated the statutory prohibition on options

on the enumerated agricultural commodities.\6\ As a consequence, the

Commission

[[Page 18822]]

initiated a pilot program to permit the reintroduction of exchange-

traded options on those agricultural commodities. The Commission

declined at that time to permit the trading of the specified

agricultural options off-exchange.\7\

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\5\ Because of continuing, persistent, and widespread abuse and

fraud in their offer and sale, the Commission in 1978 suspended all

trading in commodity options, except for trade (and subsequently,

dealer) options. 43 FR 16153 (April 17, 1976). Congress later

codified the Commission's options ban, establishing a general

prohibition against commodity option transactions other than trade

and dealer options. Public Law No. 95-405, 92 Stat. 865 (1978).

\6\ Public Law No. 97-444, 96 Stat. 2294, 2301 (1983).

\7\ 48 FR 46797 (October 14, 1983). Although the Commission

noted that ``there may be possible benefits to commercials and to

producers from the trading of these `trade' options in domestic

agricultural commodities,'' it determined that ``in light of the

lack of recent experience with agricultural options and because the

trading of exchange-traded options is subject to more comprehensive

oversight,'' ``proceeding in a gradual fashion by initially

permitting only exchange-traded agricultural options'' was the

prudent course. Id. at 46800.

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B. The Advance Notice of Proposed Rulemaking

On June 9, 1997, the Commission published an advance notice of

proposed rulemaking (advance notice) in the Federal Register seeking

comment on whether it should propose rules to lift the prohibition on

trade options on the enumerated agricultural options subject to

conditions and, if so, what conditions would be appropriate (62 FR

31375).\8\ In order to focus comment on the relevant issues, the

advance notice invited commenters to respond to 30 specific questions.

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\8\ The Commission based the advance notice on a study by the

Commission's Division of Economic Analysis (Division). The complete

text of that study, entitled ``Policy Alternatives Relating to

Agricultural Trade Options and Other Agricultural Risk-Shifting

Contracts,'' was forwarded to the Commission by the Division on May

14, 1997. It is available through the Commission's Internet site at

http://www.cftc.gov/ag8.htm.

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The Commission received a total of 76 comment letters from 82

commenters in response, almost evenly divided between those in favor

and those opposed to lifting the ban. In addition to the written

comments, the Commission received oral and written statements during

two public field meetings at which members of the public had an

opportunity to address the Commission and to answer its questions

regarding these issues. One of the meetings was held in Bloomington,

Illinois, and the other was held in Memphis, Tennessee. A third

informational briefing was held in conjunction with a general

membership meeting of the National Cattlemen's Beef Association.

Generally, speakers at these events reflected the range of views

expressed in the written comments and were likewise equally divided in

their support or opposition to lifting the prohibition on agricultural

trade options.\9\

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\9\ Transcripts of the proceedings at all three events were

included in the Commission's comment file and are available through

the Commission's internet web site.

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Many of the comments responding to the advance notice expressed the

view that the potential risk of permitting trade options clearly

outweighed any benefit which they might provide. These commenters

typically assumed that agricultural trade options would be offered

under the same level of regulation currently applicable to other trade

options.\10\ An approximately equal number of commenters expressed the

view that the prohibition on trade options should be lifted,

particularly in response to the new challenges agriculture faces as a

result of changes in government programs. The vast majority of

commenters, both those favoring and opposing lifting the prohibition on

agricultural trade options, urged caution.

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\10\ Currently, trade options and those offering them are

subject only to regulations regarding fraud. See, 17 CFR 32.4.

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C. The Proposed Rules

The Commission, based upon the analysis in the Division's study,

the comments responding to the advance notice and the commentary

presented during its field meetings, proposed rules establishing a

pilot program to permit the offer and sale of trade options subject to

a number of strict regulatory conditions. 62 FR 59624. The Commission's

proposed rules were based on its evaluation of the likely risks

associated with lifting the prohibition on agricultural trade options,

the likely immediate uses for agricultural trade options and the level

of regulation appropriate to both. The Commission proposed initially to

include within the pilot program options between commercial parties in

the normal merchandising chain for the underlying commodity, the

exercise of which would require delivery from one party to the other

either by immediate transfer of title or by transfer of a forward

contract commitment. 62 FR 59628.

The Commission further proposed to require vendors of agricultural

trade options to register as agricultural trade options merchants and

their sales forces to register as associated persons. The Commission

proposed a minimum net worth requirement of $50,000 for registration as

an agricultural trade option merchant and passing a proficiency test

for individuals to be registered as an associated person. As proposed,

agricultural trade option merchants also would have been required to

keep records, to report to the Commission and to disclose risks to

customers. The Commission also proposed several restrictions on

agricultural trade option contracts' permissible structure and use.

Four hundred forty-eight commenters responded to the notice of

proposed rulemaking, submitting a total of 441 comment letters to the

Commission. Commenters remain divided on whether the Commission should

lift the prohibition on agricultural trade options. Twelve commenters,

including among them an agricultural marketing cooperative, two

exchanges and a risk-management firm opposed lifting the prohibition in

any form. In their view, existing exchange-traded products are adequate

to manage agricultural risk, and trade options would merely replicate

existing exchange products, but in a less safe environment. The

remaining commenters supported lifting the prohibition, but differed in

their assessment of the conditions proposed by the Commission.

Of those supporting lifting the prohibition, three agreed fully

with the Commission's proposed rules. They included an association of

introducing brokers and two producer associations. The remaining

commenters opposed to varying degrees the conditions proposed by the

Commission. Twenty-four comment letters submitted by producer

associations, other agricultural associations and agribusinesses

opposed as unduly restrictive or burdensome most, if not all, of the

proposed rules.\11\ Others took exception, or offered suggestions

relating, to specific rule provisions. Two United States Senators

suggested that the pilot program be modified to permit cash settlement

of option contracts and not to limit potential vendors to those able to

take delivery of the commodity.

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\11\ The Commission also received 395 identical letters from

individual producers opposing the proposed rules on the grounds that

they result ``in the most extensive, far reaching regulatory

requirements ever imposed on cash grain marketing contracts. * * *

mak[ing] it virtually impossible for my local grain company to make

these contracts available. * * *''

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II. The Interim Rules

A. Over-all Structure

1. Pilot Program

Based upon thorough and careful consideration of the comments to

the notice of proposed rulemaking, the responses to the advance notice

of proposed rulemaking, the written and oral statements provided at the

field hearings and the Division's study, the Commission is promulgating

interim rules establishing a three-year pilot program to permit the

trading of agricultural trade options subject to the conditions

discussed below. A number

[[Page 18823]]

of commenters expressed concern that a three-year pilot program might

discourage the Commission from evaluating the interim rules and

considering their amendment until the conclusion of the full three-year

pilot period. To the contrary, however, the Commission views the pilot

program as an opportunity to monitor and to assess the efficacy of

these rules on an ongoing basis and ``to amend them as experience

warrants.'' \12\ 62 FR 59627. (Similarly, the Commission's

implementation of the 1982 pilot program to reintroduce exchange-traded

commodity options included a number of rule amendments during the

program and before its termination.)

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\12\ The Commission noted in the notice of proposed rulemaking

that ``it will evaluate the efficacy of the interim final rules at

the conclusion of the pilot program.'' 62 FR 59627, n.19. That does

not suggest, however, that the Commission will not consider altering

the interim rules during this period, but only that it is the

Commission's intention not to make the interim rules final until a

full review of the pilot program experience.

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Several commenters expressed concern that the Commission, in

connection with its final consideration of permanent rules, is unlikely

to revisit or to reconsider the fundamental policy decisions relating

to its present determination of the pilot program's overall structure.

They suggested that the Commission delay promulgating interim rules and

repropose an entirely different set of regulatory conditions which

would apply to the trading of agricultural trade options, including

permitting them to be cash-settled.

The Commission disagrees with this suggested approach. The

Commission views the pilot program as an experiment, has not foreclosed

the reconsideration of any specific issue and, by determining that

particular rules are appropriate at the initiation of the pilot

program, has made no judgment regarding the permanent rules that it

ultimately will promulgate. The Commission believes that proposing a

new set of rules without any market-based experience would foster delay

and provide little additional substantive information to inform its

decision on how to proceed. For this reason, the Commission believes

that the public interest will best be served by making agricultural

trade options available to the market now under the regulatory

structure as proposed and by consideration of possible amendment of the

interim rules based upon actual market experience.

2. Physical Delivery

The overall structure of the interim rules adheres closely to the

proposal. The interim rules, like the proposed rules, permit only the

trading of off-exchange agricultural options that if exercised, would

require physical delivery from one commercial party to another in the

normal merchandising chain. In proposing this provision, the Commission

reasoned that such options would explicitly include a merchandising

function which exchange-traded contracts did not, that such options

would be between those having pre-existing cash market relationships

and that the mechanics of these options were likely to be well-

understood. See, 63 FR at 59627.

A number of comments, including one from two United States Senators

and a joint comment of seven farm and commodity representative

organizations (joint comment), suggested that the Commission also

include within the pilot program cash-settled options. However, not all

commenters agreed with this view. For example, one state-level farm

organization strongly supported the proposed provision requiring

physical delivery, noting that it was:

in complete agreement * * * that the off-exchange agricultural trade

option be settled by either delivery of the physical commodity or by

the writing of a forward contract which will guarantee delivery. To

allow a cash-settled instrument would potentially foster cash

speculation between vendors and buyers.

Many of those advocating inclusion of cash-settled options

suggested that the proposed physical delivery requirement would

preclude any flexibility in the type of options that could be offered,

making it impossible, for example, to offer options combining

production and price protection--so called ``revenue'' contracts.

Revenue option contracts would enable producers to lock in a minimum

revenue for production on their farms. An association representing

grain elevators reasoned that:

[t]he rules, as written, provide no apparent authority to write

revenue contracts combining both yield and price risk management

into one contract. * * * [R]evenue contracts that could utilize the

yield contracts offered by the Chicago Board of Trade to shift a

substantial part of this risk are, in our view, very important to

the farmer. They are also important to the cash grain industry in

having the opportunity to work along side the insurance industry in

offering a more ``complete'' line of futures-based revenue

contracts. We strongly urge the CFTC to include revenue contracts

(and other legitimate agricultural trade option contracts where

physical delivery is not possible) under the pilot program.

(Emphasis omitted.)

The physical delivery requirement does not preclude development of

revenue-type option contracts. Nothing in the rules requires that the

trade option specify the underlying commodity by referencing an

absolute number of bushels or other delivery unit. The amount of the

commodity underlying the option could be expressed by referencing the

yield on a designated number of acres, based either on the producer's

actual yield or a reported average yield, thereby providing a minimum

return to a producer per acre without running afoul of the rules'

requirements. If the total price for the amount of commodity required

to be delivered were above the guaranteed price, the producer would let

the option expire and deliver outside of its terms. If the total price

were below the option's strike price, the producer would exercise the

option, delivering his or her production to the option writer.\13\ The

Commission anticipates that a wide variety of option structures could

be designed to offer additional forms of revenue protection under the

pilot program's rules and invites those interested in developing such

instruments to seek its guidance if questions arise regarding their

permissibility.

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\13\ It is common practice for certain commodities to provide a

cash adjustment where the commodity delivered departs from quality

or other contract specifications, including tolerances for the

actual amount or weight delivered compared to the contract amount.

Similarly, if a state-wide average yield were used as a reference

and the producer's actual production fell somewhat short, the total

price could be adjusted to account for the relative shortfall

without abrogating its fundamental nature as a delivery contract.

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A number of commenters similarly objected that the proposed rule

requiring that agricultural trade options be settled only by physical

delivery further unduly restricted their potential flexibility and

utility by forbidding their early termination through offset. This

requirement was proposed as a means to ensure that agricultural trade

options maintain a close relationship to the cash market activities of

participants and to dissuade speculative use of the contracts. Several

commenters, however, argued that a producer's ability to capture any

remaining value left on the option by selling the option back to the

issuer under the terms of the original contract when the optional price

protection was no longer wanted was not inconsistent with these

objectives.

However, permitting the offset of an option prior to its expiration

would render meaningless the provision requiring physical delivery of

the option, if exercised. The right to offset would eviscerate the

physical delivery requirement by enabling the option

[[Page 18824]]

holder at any time to avoid delivery, essentially cash-settling the

option.\14\ This would undermine the Commission's efforts to develop a

pilot program to reintroduce agricultural trade options under

controlled conditions.

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\14\ See, CFTC Interpretive Letter No. 96-41, Division of

Economic Analysis Statement of Policy in Connection with the

Unwinding of Certain Existing Contracts for the Delivery of Grain,

[1994-1996 Transfer Binder] Comm. Fut. L. Rep. (CCH) para. 26,691

(Division of Economic Analysis) for a discussion of impermissible

offset provisions.

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Although the interim rules have not been modified to permit the

offset of agricultural trade options, the rules as proposed permitted a

degree of flexibility to capture an option's remaining value prior to

its expiration. The proposed rules recognized that agricultural trade

option contracts could be amended to ``reflect changes * * * [in]

activity or commitments in the underlying cash market or to reflect the

carrying of inventory.'' 62 FR at 59638.\15\ Such amendments could

include deferral of an option contract's delivery date with alteration

of the contract's price to reflect, among other adjustments, any

remaining value on the original option.\16\

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\15\ Proposed rule 32.13(a)(7)(i) (paragraph of required

disclosure statement entitled ``Business Use of Trade Options'').

\16\ Accordingly, proposed rule 32.13(a)(7)(ii)(D) required

disclosure of the worst possible financial outcome where ``through

amendments to the option contract it is possible to lose more than

the amount of the initial purchase price.'' 62 FR 59638.

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The proposed rules also contemplated that delivery on an option

contract, if exercised, could be by the ``immediate transfer of title

to the commodity or by transfer of a forward contract commitment.'' 62

FR 59627. Proposed rule 32.13(a)(3)'s requirement that the ``option can

only be settled through physical delivery of the underlying commodity''

should be read as permitting termination of the option contract prior

to its expiration through entry into a forward contract commitment as

well as permitting use of a forward contract upon exercise. Once the

forward contract has been substituted for the trade option, the forward

contract is a firm commitment to deliver, and the optional ``walk-

away'' nature of the option cannot be reestablished. The substitution

of a forward contract for the physical delivery option prior to the

option's expiration is consistent with the overall purpose of the rule

of maintaining a close relationship between the option transaction and

the participant's cash market activities and of dissuading use of

agricultural trade options as speculative vehicles. The Commission is

modifying the interim rule to clarify that settlement of the option by

physical delivery does not preclude the option contract's amendment, or

its termination by entry into a forward contract, prior to expiration

with an appropriate adjustment to the contract price.\17\

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\17\ A price adjustment to reflect the remaining value of the

trade option contract upon substitution of a fixed-price forward

contract for the option is consistent with the treatment accorded

minimum price guaranteed forward contracts by Commission staff. The

Division of Economic Analysis in CFTC Interpretative Letter 96-23,

(Re: Sections 1a(11) and 2(a)(1) of the Commodity Exchange Act--

Request for Guidance Regarding Producer Option Contract), [1994-1996

Transfer Binder], Comm. Fut. L. Rep. (CCH) para.26,646, expressed

the view that, within a forward delivery contract offering a

guaranteed minimum price, the holder of the contract could elect to

eliminate the upside pricing potential (the option-like pricing

component) in the contract in return for establishing a fixed price

forward contract, the price of which was adjusted to reflect the

liquidated remaining value of the option component. The option-like

pricing component could not, however, be reestablished in the

contract.

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3. Eligible Vendors

A number of commenters also advocated expansion of those eligible

to be agricultural trade option merchants to additional classes of

vendors. Specifically, for example, the joint comment suggested that

all ``financial institutions with a direct interest in production

agriculture'' be permitted to become agricultural trade option vendors.

Other commenters supported the Commission's proposed limitation,

suggesting that trade options appropriately should be limited to

``producers and buyers of the enumerated commodities.''

Several commenters opposed the conditions for registration as an

agricultural trade option merchant on the assumption that eligibility

would be restricted to ``first handlers'' of the commodity. Although

first handlers typically would be eligible to become agricultural trade

option merchants, other categories of commercial users would also be

eligible to apply for registration. For example, as one commenter

noted, ``[w]e assume the CFTC would also permit cash grain

merchandisers, which have no facilities, but do take title to

commodities, to also write options.'' As discussed above, the

requirement that the option contracts, if exercised, be physically

delivered does not require that the agricultural trade option merchant

accept delivery only in an over-the-scales operation. To the contrary,

delivery of the commodity can occur through any bona fide means of

conveying legal ownership of the commodity, including the transfer of

warehouse receipts. Accordingly, grain merchants, investment bankers

with active commodity trading operations and various types of

agricultural processors or commercial users of the commodity might be

eligible to register to operate as an agricultural trade option

merchant. In light of the potential diversity of eligible registrants,

the Commission believes that the interim rules will not result in lack

of competition among vendors.\18\

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\18\ One comment letter questioned whether agricultural

cooperatives would be able to meet the net worth requirement for

registration as an agricultural trade option merchant by combining

the individual net worth of each member. Generally the rules do not

distinguish cooperatives from any other type of enterprise.

Accordingly, the cooperative must itself have a net worth of $50,000

to meet the applicable requirement. To the extent that cooperatives

act on behalf of members as a commodity merchandiser, they may

purchase agricultural trade options in connection with their

merchandising function. Of course, in doing so they would have to

have the contractual right to deliver the commodity to settle those

options which they choose to exercise.

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The Commission is convinced that the overall structure of the

interim rules is both a necessary and appropriate means to introduce

this new class of instrument. Recent experience with various types of

agricultural marketing schemes and contracts indicates that a degree of

caution is required. Introducing these instruments as a pilot program,

limited initially to option contracts which upon exercise result in

physical delivery, traded between commercials in the underlying

commodity, should provide a degree of protection to the parties and a

solid foundation upon which to lift the current prohibition on such

instruments.

As discussed above, the proposed rules provided greater flexibility

than credited by many of the commenters. Moreover, in the interim rules

the Commission has modified or clarified the rules as proposed,

providing further avenues for flexibility. The Commission is convinced

that the interim rules will provide the market with room to innovate

and to create useful risk-management tools within its overall

structure.

Moreover, the interim rules have been modified from the proposed

rules in a number of important respects apart from issues relating to

the pilot program's overall structure. In response to specific

suggestions by commenters, the interim rules clarify and streamline

several specific regulatory requirements. In several instances, the

interim rules significantly lessen the burden that the proposed rules

would have imposed on those who register as agricultural trade option

merchants and their sales forces, as well as the requirements relating

to

[[Page 18825]]

the merchant's on-going business operations. These modifications are

intended to achieve the same regulatory goals, and provide a similar

degree of protection, as the rules as proposed, but in a less costly or

burdensome manner. The specific changes are discussed in greater detail

below.

B. Regulation of Agricultural Trade Option Merchants

1. Registration

Registration of commodity professionals is an important means by

which the Commission polices the futures and option industry and is the

primary mechanism for reassuring the public of the honesty and

proficiency of futures professionals. As the Commission noted in its

notice of proposed rulemaking, ``registration * * * will be critically

important in the decentralized market permitted under the pilot

program.'' The notice further noted, however, that the need for

extensive registration requirements is offset by the fact that the

offer and sale of trade options would be a complement to the first-

handler's existing cash market businesses. Accordingly, the Commission

proposed a streamlined form of registration, consisting of a single

application form covering both the agricultural trade option merchant

as an entity and its authorized sales force.

The Commission also proposed to delegate administration of the

registration function to the National Futures Association (NFA).

Although some commenters opposed this on the grounds that it would

``permit another user-fee based regulator * * * to initiate far-

reaching regulatory activities among cash market businesses,'' the

delegation to the NFA is narrow, confined to administration of the

registration function,\19\ and necessary to conserve Commission

resources.

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\19\ Fees will be limited to the cost of this one function and

are expected to be modest.

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Based upon its administrative experience, NFA suggested a number of

modifications to the proposed registration rules. In its view, a single

application for registration of the agricultural trade option merchant

and its sales force ``rather than providing a streamlined registration

process, * * * will unduly complicate and actually hinder the

registration of ATMs.'' Because the Commission's ultimate goal is for

the overall registration process to be streamlined, the Commission has

incorporated the NFA's suggestions into the interim rules. Accordingly,

agricultural trade option merchants and their associated persons will

be required to file separate registration applications, each focussed

specifically on the requirements for that category of registrant.

Separate forms in support of the agricultural trade option merchant's

application for registration are also required of the natural persons

who are its principals. Individual application forms for each category

should result in greater simplicity for each and not in an increase in

the total length of the applications or in the amount of information

provided.

NFA also suggested a number of rule clarifications, including the

addition of definitions of the registration categories and

incorporation by explicit reference of the procedures for denial,

suspension and revocation of applications for registration which are

applicable to all classes of registrant under the Commission's rules.

The interim rules have been modified to reflect these technical

changes.\20\

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\20\ The Commission's explicit application of various of its

procedural rules to agricultural trade option merchants and their

associated persons in no way limits the applicability of any other

statutory or regulatory provision which is applicable to Commission

registrants. In this regard, the Act and many of the Commission's

rules impose requirements or prohibitions on Commission registrants

using the phrase ``any person or registrant who is registered under

this Act'' or similar words. For example, Section 14 of the Act

provides aggrieved customers with the opportunity to bring before

the Commission for adjudication disputes involving violations of the

Act or rules by ``any person registered under this Act.'' See also,

17 CFR 3.34, 3.56, 3.60. Although ``agricultural trade option

merchant'' and ``associated person of an agricultural trade option

merchant'' are not registration categories defined by the Act, they

are nevertheless registration categories ``under the Act'' by virtue

of the Commission's promulgation of rules creating these

registration categories under section 4c(b) of the Act (its plenary

authority over the regulation of options) and under section 8a(5) of

the Act (its general rulemaking authority). The Commission's

reparations program under section 14 of the Act will therefore be

available to customers of agricultural trade option merchants and

their associated persons as it is for all other categories of

Commission registrant. Customers will be apprised of this right in

the required summary disclosure document.

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Many commenters offered the view that the proposed registration

requirements for agricultural trade option vendors should be relaxed.

This view was shared by both potential customers and vendors alike. The

joint comment noted the agricultural associations' ``concern () that

the high level of specific regulation * * * will impose excessive costs

* * * that are not reflective of, or proportionate to, the risks

associated with removing the ban * * * for a narrowly defined range of

products.'' Specifically, the joint comment suggested that the

fingerprint requirement was unnecessary and that the proficiency and

ethics training requirements be relaxed. A company active in the cash

grain business noted that ``[r]egistration for those organizations

offering ATOs in the pilot program period seems reasonable, but the

imposition of testing requirements, ethics training, and fingerprinting

push the regulatory oversight of these products beyond a reasonable

limit.''

The Commission has reconsidered these proposals in light of similar

comments received from a broad range of commenters. The reason that

fingerprints typically are required of registrants is to perform a

background check verifying the information submitted on the

registration application. This requirement may be less necessary in the

context of agricultural trade options where a likely characteristic of

the market is a pre-existing commercial relationship between the vendor

and customer. The likelihood of such a relationship is reinforced by

the requirement that options, if exercised, must be physically

delivered. That requirement generally will tend to keep the markets

local, where there is a greater likelihood that customers will have

personal knowledge of the background of the agricultural trade option

merchant and its sales force.\21\ Accordingly, the Commission has

removed this requirement from the interim rules, and because the

primary delay in processing registration applications has been

associated with fingerprint checks, the Commission has also removed

from the interim rules provisions relating to temporary licensing of

registrants.

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\21\ The local nature of cash marketing channels is typical for

many, but certainly not all, commodities. The interim rule's

requirements must generally be understood within the normal cash

marketing channels for each commodity. For some commodities, normal

cash marketing channels include delivery obligations being

undertaken as to processors or users at a considerable distance from

producers.

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The interim rules modify the requirement that persons applying for

registration pass a competency test and fulfill an ethics training

requirement. Many commenters representing both potential customers and

vendors suggested that the testing requirement would dissuade

individuals from registering, particularly because this would be a

sideline to their core cash-businesses. Several commenters specifically

objected that the Series 3 examination, which was included in the

proposed regulations as a permissible alternative to a more focussed

test not yet developed, would not be relevant to these products.

As noted in the advance notice, a competency test is only one means

for ensuring the market vendors have the

[[Page 18826]]

requisite professional and market knowledge. Development of a testing

program specifically focussed on this market may be premature in light

of the unknown number or composition of potential vendors and the

existing tests' admitted lack of direct relevance to these products.

However, almost all those commenting agreed that education was needed.

Many organizations representing both likely customers and potential

vendors suggested that this education be voluntary and stated an

intention to offer educational training opportunities to their members.

As the Commission noted in its notice of proposed rulemaking,

``customers have the right to expect that such merchants and their

sales forces will have successfully demonstrated mastery of the issues

relevant to the offer or sale of these instruments.'' 62 FR 59630, n.

35. In order to provide customers with some assurance that this

expectation will be met, the interim rules substitute for the proposed

competency test a requirement that those seeking registration as

associated persons of an agricultural trade option merchant complete

six hours of instruction in the requirements of the Act and rules

promulgated thereunder, the economic functioning and risks of

agricultural trade options, and the registrant's responsibility to

observe just and equitable principles of trade relating to such

options. This course of instruction includes among others, the subjects

which would have been specified by the proposed ethics training

requirement. Accordingly, that proposal has been deleted. Instruction

can be by videotape or electronic media and need not be through

classroom attendance.

The applicant for registration as an associated person must include

in the application evidence provided by an eligible instructional

provider that the applicant completed this instructional requirement.

This evidence of completion must include a certification that the

instructor has three years of relevant experience, is not subject to a

statutory or other disqualification and a disclaimer that the

Commission or the NFA has not approved the course of study's

content.\22\ Instructors must notify the NFA of their intent and

eligibility to offer such training prior to doing so, and must maintain

appropriate documentation of applicants' completion of the requirement.

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\22\ At least one commenter, a large grain merchant, commented

that it provided in-house ethics and business training for its

employees. In-house training by an agricultural trade option

merchant for its associated persons is not precluded by these rules,

nor is the use of employees as instructors. Employee-instructors

meeting the requisite requirements will be qualified to certify

fulfillment of the training requirement for other employees. Such

employee-instructors, however, cannot be the direct supervisor of

the associated person applying for registration.

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There is no educational requirement for customers. However, as the

Commission previously stated:

it strongly urges private sector organizations to provide a variety

of means of fulfilling this need. The success of the pilot program

will depend, in part, on the success of various organizations in

educating potential trade option customers.

Id.

2. Financial Requirements

The Commission, in proposing various financial protection

requirements, noted that agricultural trade options, like all commodity

futures or option instruments, involve risk arising from the need for

performance at a future date by the contract's counterparties. Off-

exchange transactions such as these, however, do not have the safety of

an exchange clearinghouse to reduce credit risk. Because many

agricultural trade option customers will not have the resources to

conduct formal credit worthiness evaluations of their counterparties,

the Commission proposed that agricultural trade option merchants be

required to maintain a minimum level of net worth and to segregate from

their own funds premiums paid by customers at initiation of an option

contract. It did not propose requiring agricultural trade option

merchants to cover their market exposure. 62 FR 59628-59630.

The Commission proposed the minimum net worth requirement ``to

establish a base level for entry or access to a market * * * to assure

that companies or entities conducting business offer some assurance of

having the financial wherewithal to perform on their obligations.'' 62

FR 59628. Commenters on the advance notice were not unanimous in

support of such a minimum financial requirement. Some were opposed in

order not to exclude smaller entities, and others argued that various

state financial requirements would be sufficient. Believing that a

common federal minimum standard should prevail, the Commission proposed

to apply to agricultural trade option merchants the $50,000 minimum net

worth requirement established by the United States Department of

Agriculture (USDA) (and many states) as a condition of obtaining a

federal grain warehouse license.

A number of commenters took issue with the $50,000 minimum net

worth requirement, suggesting that it was too low. The joint comment

suggested that agricultural trade option merchants be required to

``maintain a bond equal to * * * premiums of all customer options less

the current cash value of the contracted commodities in addition to

existing state or federal bonding requirements.'' One potential vendor

recommended a minimum net worth of $1 million with adjustments ``to

require that the risk exposure of a seller of options has an

appropriate relationship to the seller's net worth,'' reasoning that

``one of the greatest risks to the development of an efficient

agricultural trade option market is that undercapitalized sellers of

the options will default.'' Other commenters supported the proposed net

worth requirement as an appropriate minimum level.

The Commission agrees that the $50,000 net worth requirement will

offer only limited protection from counterparty default risk. However,

the price risk to the agricultural trade option merchant of an option

position will be similar to that of a forward contract position.

Greater financial protection would indeed be achieved, as suggested by

several commenters, by requiring vendors to post bond or to maintain

increasing levels of net worth as the degree of exposure rises.

Nevertheless, constructing a meaningful regulatory scheme to achieve

that goal, however appealing the concept, would result in rules which

are far more complex than any of those proposed, including rules on

uniformly valuing various risks. In this regard, the rules governing

computation of regulatory capital which must be maintained by futures

commission merchants are among the most complex of all of the

Commission's rules. In addition, such a dynamic valuation requirement

would require a degree of regulatory supervision that would be

difficult if not impossible to achieve in this decentralized, over-the-

counter market.\23\ In these circumstances, the suggested bonding

requirement might lull market participants into a false sense of

security. Accordingly, the Commission is adopting the minimum net worth

requirement as proposed.

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\23\ The regulated futures markets provide a high level of

financial protection through their clearinghouses. Each exchange has

a compliance and audit staff, and clearing members and futures

commission merchants devote significant resources to auditing for

compliance with the various financial requirements. The Commission

cannot offer comparable protection for transactions outside of the

regulated exchange environment. Customers must accept the fact that

trading off-exchange entails greater counterparty risk.

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The interim rules, as proposed, provide that the net worth

requirement is ongoing in nature, requiring

[[Page 18827]]

agricultural trade option merchants to maintain the specified level of

net worth in order to enter into new trade option contracts and

requiring them to notify the Commission at any time if they have fallen

below prescribed levels. In addition, the agricultural trade option

merchant must perform a reconciliation of its financial position at

least monthly to determine compliance with this requirement. It need

not change accounting procedures to conform to specific Commission

accounting requirements, provided it uses ``fair value'' accounting

under Generally-Accepted Accounting Principles, the accounting method

generally used by cash market businesses.\24\

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\24\ The Commission believes that the guidance provided in the

American Institute of Certified Public Accountant's Audit and

Accounting Guide entitled ``Brokers and Dealers in Securities''

provides the relevant guidance which should be followed in

connection with assigning a fair value to agricultural trade

options. It states, ``Under generally accepted accounting

principles, fair value is measured in a variety of ways depending on

the nature of the instrument and the manner in which it is traded.

Many financial instruments are publicly traded, and end-of-day

market quotations are readily available. Quoted market prices, if

available, are the best evidence of the fair value of a financial

instrument. If quoted market prices are not available, management's

best estimate of fair value should be based on the consistent

application of a variety of factors available to management.'' A

complete discussion of the factors is provided in the audit guide.

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However, the interim rule has been modified from the proposed rule

which required agricultural trade option merchants to hold in

segregation all premiums paid by customers at the initiation of the

option contract. Several commenters suggested that the requirement as

proposed would discourage vendors from responsibly covering the risk of

the transaction and suggested that the Commission permit vendors to use

customer premiums to hedge that risk. The Commission proposed the

segregation requirement both as a means of discouraging a business in

financial difficulty from writing options to generate immediate cash

and as a means of better safeguarding customer funds. 62 FR 59629.

Permitting the vendor to hedge the option's risk using the customer's

funds, particularly if the covering transaction is exchange-traded,

also achieves these objectives. Accordingly, although the Commission is

not mandating that agricultural trade option merchants cover their

risk, the interim rules permit the merchant to use up-front customer

premiums to hedge those risks using exchange-traded instruments.

Customer funds not used for this purpose, as proposed, must be treated

as the funds of the customer and be kept in a segregated account.\25\

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\25\ An agribusiness company commented that the rules ``should

indicate (like Sec. 1.25) that the seller of the options can invest

funds in government obligations to earn interest.'' The proposed

(and interim) rules so provide. See, paragraph (e) of Sec. 32.6,

incorporated by reference in proposed rule 32.13(a)(4).

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3. Recordkeeping and Reporting Requirements

In proposing recordkeeping requirements, the Commission reasoned

that ``the maintenance of full, complete, and systematic books and

records by agricultural trade option merchants is crucial to the

Commission's ability to respond to complaints of customer abuse arising

from such transactions and is necessary to the agricultural trade

option merchant's establishment of appropriate internal controls of

their financial operations.'' 62 FR 59633. Most commenters agreed and

supported the requirements as proposed. At least one commenter,

however, questioned the requirement that a record of unfilled or

canceled contract orders be kept. It reasoned that ``[r]ecording all

orders and cancellations will likely provide little insight to the CFTC

when compared to the arduous task of tracking these records for those

offering these products.'' This recordkeeping requirement, however,

serves a different purpose than informational reporting to the

Commission. The keeping of complete books and records is necessary to

resolve particular customer disputes, if they arise, and is a sound

business practice. The Commission therefore is adopting the

recordkeeping rule as proposed.\26\ However, the Commission has

modified the interim rule by deleting the NFA's proposed authority to

inspect books and records at the request of the NFA and as suggested by

other commenters.

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\26\ As proposed, the final rules require that records relating

to agricultural trade options including covering transactions must

be kept and maintained for a period of five years and must be

readily accessible during the first two years of that five-year

period. See, 17 CFR 1.31.

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In addition to the keeping of books and records, the Commission

proposed two distinct reporting requirements--routine and special call

reporting. Routine reports are required for general market surveillance

purposes, to permit the Commission to construct a picture of the market

and to evaluate the impact of activity in the trade option market on

the cash and exchange-traded markets.\27\ One commenter suggested that

information on the total premiums collected and the total value of all

fees, commissions, or other charges during the reporting period was not

necessary to this surveillance function. The Commission agrees, and the

interim rules do not require the routine reporting of premiums, fees,

commissions, or other charges. However, this information may be helpful

to a complete understanding of the market's operation, particularly

during the pilot phase of the rules. Accordingly, the Commission is

retaining the authority to request such information on a special call

basis.

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\27\ Initially, the Commission anticipates that such reports

will be filed manually, including by facsimile. However, it also

anticipates that as the pilot program proceeds, reports will be

filed electronically, by dial-up transmission or via the Internet.

The NFA, which has been delegated authority to collect these

reports, is encouraged to work cooperatively with the industry in

advancing appropriate procedures, conventions and standards for

electronic transmission.

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Special calls are a reporting device used by the Commission for

obtaining information only when needed. A special call may be used to

elicit information from a particular trader or registrant for market or

financial surveillance purposes or to gather data for market-wide

studies. As the Commission explained in the notice of proposed

rulemaking, it anticipates the need to issue special calls for

information during the pilot program to gather data with which to

assess its success. 62 FR 59633. At least one commenter suggested that

the proposed rule be clarified that the agricultural trade option

merchant ``be required to report * * * only the `options' portion of

the * * * position.'' As proposed, rule 32.13(e) in the introductory

paragraph stated that special calls were for ``information relating to

agricultural trade options.'' However, to clarify further the

provision, the Commission is modifying the rule as adopted to provide

that the information which can be requested by special call concerning

futures or cash transactions must be related to the agricultural trade

option position. In this regard, potential agricultural trade option

merchants should be assured that the Commission exercises its existing

special call authority in other markets with restraint and with an

understanding of the costs involved in any such request. As noted in

the notice of proposed rulemaking, the Commission encourages

agricultural trade option merchants to maintain a current listing of

customers names and other identifying information for ease of

compliance.\28\

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\28\ Generally, a special call for study purposes requests

specified information on all positions open on the call date. The

Commission expects that any special calls would request information

related to a customer's positions in agricultural trade options

along with the customer's name and other identifying information. In

the past, some firms have maintained some, but not all identifying

information at a central location, and branch locations have kept

the remaining information in differing formats, creating difficulty

in providing the information requested. Accordingly, in setting up

their information systems, firms should keep in mind the likelihood

of a request for this information during the pilot program.

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[[Page 18828]]

C. Customer Protections--Risk Disclosure, Required Contract Terms and

Required Account Information

1. Risk Disclosure Statement

Almost all commenters agreed that required risk disclosure was a

valuable and necessary means of protecting customers. In promulgating

the interim rule, the Commission has clarified the requirement that

both an initial summary risk disclosure statement and transaction-

specific disclosure statements be provided.

Many of the commenters opined that the proposed summary risk

disclosure was too lengthy and feared that many customers would forego

reading it. The Commission after reviewing the proposed summary

disclosure statement has shortened it by deleting some redundant

information, by further summarizing other information and by

simplifying its language.\29\

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\29\ One commenter opined that the reparations language of the

summary disclosure document was unclear as to its impact on the

availability of other venues for dispute resolution, such as

arbitration offered under the auspices of a trade association. The

language of the summary disclosure document has been modified to

make clear that all customers have the right to use the Commission's

reparations program to resolve disputes. Thus, the customer may not

be compelled to waive this right by any other provision in the

customer agreement or elsewhere. Customers may, however, voluntarily

agree to an alternative method of dispute resolution specified in

the customer agreement, the contract or elsewhere. Compare,

Commission Regulation 180.3(b)(3).

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Some customers opposed the transaction-specific disclosure,

objecting that this requirement would prove to be burdensome for the

limited sales forces many agricultural trade option merchants may

employ. Other commenters strongly supported it, noting that the

transaction-specific disclosures are necessary to a customer's

understanding of the nature of the option transaction being entered.

The Commission concurs. The transaction specific disclosures need not

be voluminous, are not required to be in a separate document and can be

included as an addendum to the contract form itself. Although some

commenters objected to the requirement that the worst possible

financial outcome be disclosed, that requirement is only triggered when

the option premium is not collected up front or when the contract is

amended. The worst possible outcome need not take into account lost

opportunity cost--therefore, it often will only be the potential loss

of the premium and other related charges. Where a contract is being

amended, such as by rolling the delivery date, the worst possible

outcome will include the cost of the additional premium, fees and

adjustment to the price resulting from any gain or loss on the contract

at the time of the amendment or contract roll. In light of the

imperfect understanding many hedge-to-arrive customers had of the

effect of rolling on their final contract price, such a disclosure is

plainly needed. Accordingly, the Commission is adopting this rule as

proposed.

As the Commission explained in the notice of proposed rulemaking,

``the provision of the mandatory risk disclosure statement will not

relieve the agricultural trade option merchant of the responsibility to

avoid material misstatements or omissions or any other form of

fraudulent misconduct.'' 62 FR 59632. Thus, providing a mandatory risk

disclosure statement will not necessarily cure what is otherwise fraud.

See, e.g., Clayton Brokerage Co. v. Commodity Futures Trading

Commission, 794 F.2d 573, 580-581 (11th cir. 1986). Accordingly,

agricultural trade option merchants may need to make such additional

disclosures as necessary in light of all the particular circumstances,

including the nature of the instrument and the customer.\30\

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\30\ One commenter suggested that the Commission clarify that

the disclosure statement could be electronic. The Commission agrees

and has clarified that electronic disclosure is permitted.

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2. Written Contract Terms

Generally, commenters supported the proposed rules requiring that

specific contract terms be in writing. However, several commenters

objected to the proposed requirement that the written contract terms

include the quality or grade of commodity to be delivered if the

contract is exercised and any adjustment or price for deviation from

stated quality or grade. One commenter, a cash grain merchant, stated

that the proposed requirement was not consistent with cash market

practice. That commenter stated that:

transactions are established in most instances, for a specific

quality of grain. * * * To the degree that the actual grain

delivered under these agreements fails to meet the standard grade

specified in the contract, the buyer and seller must determine the

impact on the value of the commodity delivered, and negotiate

discounts/premiums accordingly.

Others active in the cash markets agreed, nothing that common cash

market practice is for a forward contract to specify price for a

standard commodity grade and for adjustments to be made for variance

from this specification by reference to posted schedules of discounts

or premiums. Reportedly, these schedules vary frequently, often daily.

In light of these comments, the Commission is modifying the interim

rule to make clear that an exact schedule of discounts/premiums need

not be specified and that such adjustments can be stated as a range and

method for determining adjustments, such as ``posted market scale of

discounts at delivery.''

3. Customer Account Information

Many commenters supported the proposed requirement that

agricultural trade option merchants provide customers with information

regarding their positions and accounts. However, several noted that the

monthly account statement would impose a costly informational burden

for a questionable benefit. They explained that few entities likely to

become agricultural trade option merchants have available the

information infrastructure to produce monthly account statements

valuing the transactions and that such information would be of only

marginal utility to customers in light of the requirement that option

contracts must be settled by delivery. The Commission finds this

persuasive and is modifying the monthly account statement requirement

to provide that the agricultural trade option merchant notify customers

of the expiration date of each option which will expire within the next

month. This should greatly reduce the informational burden on

agricultural trade option merchants but nevertheless provide customers

with notice sufficient to reduce the occasions on which customers

permit in-the-money options to expire due to inattention.\31\

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\31\ At least one commenter representing producers suggested

that, although the monthly account statement requirement might be

unduly burdensome, agricultural trade option merchants as a matter

of best practices should periodically update their customers on

market conditions, particularly during times of high volatility. The

Commission agrees that this is desirable and will consider further

the issue of periodic customer statements based on experience under

the pilot rules.

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In addition to the monthly account statements, the Commission

proposed that agricultural trade option merchants provide customers in

writing, within twenty-four hours of a request, current commodity price

quotes or other information relevant to the customer's position and

account. A number of

[[Page 18829]]

commenters supported this requirement, but others suggested that it

could prove to be an undue burden, particularly because it required a

written response within so short a time. In light of the modification

of the monthly account statement requirement discussed above, the

requirement to provide customers with account-related information upon

request is of even greater importance. However, the Commission is

modifying the interim rule to lessen the burden which it imposes by

requiring that all responses be in writing. This may be particularly

useful where the requested information relates mainly to market

conditions or quotes and the agricultural trade option merchant

provides an immediate response by telephone. The customer may ask,

however, that the information be supplied in writing, and under the

rule as modified the agricultural trade option merchant must do so

within 48 hours of the request. These modifications should strike the

appropriate balance between providing customers with timely account-

related information and the burden on the agricultural trade option

merchant of doing so.

D. Exemption for Sophisticated Entities

The Commission proposed to exempt individuals or entities who are

commercials and have a net worth of at least $10 million from

compliance with the conditions for trading agricultural trade options.

Several commenters suggested that the Commission clarify whether a high

net worth entity acting as a vendor would be exempt from the rules'

requirements. The exemption applies only to high net worth entities

trading among themselves. If an option customer does not meet the net

worth requirement, the agricultural trade option merchant must comply

with all of the rules applicable to such option transactions.

In addition, a number of commenters suggested that the Commission

clarify that the exemption also applies to the associated registration

requirement and to the trade option prohibition itself. The Commission

has done so. However, it should be equally clear that the exemption

from the conditions under which the prohibition is being lifted is not

independent of the pilot program, but rather part of it. Thus, the

exemption for high net worth individuals and entities will be the

subject of Commission oversight and may be reconsidered, as with any

other of the interim rules, based upon market experience during the

pilot period.

Several commenters questioned the reason for, and the effect of,

the higher dollar level for this exemption than the exemptions

applicable to high net worth persons under parts 35 and part 36 of the

Commission's rules.\32\ The Commission remains convinced that the

dollar level of this exemption is appropriate and is adopting it as

proposed. The exemptions under parts 35 and 36 were promulgated a

number of years ago, and the Commission has announced that it will

publish a concept release seeking comment on them. Issues relating to

the dollar level of those exemptions are more appropriately considered

in that context.

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\32\ The Commission explained in the notice of proposed

rulemaking that, ``[u]nder parts 35 and 36, corporations or

partnerships having total assets exceeding $10 million or net worth

of $1 million in cases where the transaction was entered into in

connection with the conduct of its business or to manage the risk of

an asset or liability, are considered eligible for the exemption.

Some have observed, however, that these qualifying amounts when

applied to entities in agriculture are too low given the relatively

large investment in land and equipment needed to operate a farm. The

concern is that a relatively large number of individuals engaged in

agriculture might meet these financial criteria based not so much on

their investment sophistication and ability to gather and manage a

sizable asset portfolio, but rather simply reflecting the need to

acquire a threshold level of land and machinery to operate

successfully a farm or agricultural enterprise. Accordingly, the

Commission is proposing that, to qualify for this exemption,

individuals or entities should have a net worth of at least $10

million.'' 62 FR 59634.

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One commenter representing swaps dealers requested that the

Commission clarify that the part 35 exemption applies to off-exchange

agricultural options rather than this exemption. The Commission

disagrees. Any off-exchange option on an enumerated agricultural

commodity must comply with Commission rule 32.13(g) for exemption from

the Act and Commission rules, and no other exemptive provision is

available.\33\

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\33\ In supporting its view, the commenter suggested that the

Commission ``clarify that the restrictions on the use of

agricultural trade options do not limit the scope of the Swap

Exemption,'' citing the study of the Commission's Division of

Economic Analysis. The commenter further stated that in that way,

``the CFTC will eliminate uncertainty.'' Promulgation of this

exemption which explicitly is applicable to options on agricultural

commodities eliminates any such uncertainty.

---------------------------------------------------------------------------

Another commenter suggested that the Commission modify the proposed

rule to exempt transactions ``between parties whose obligations under

the option contract are guaranteed by a high net worth affiliate.'' The

Commission recognizes that certain sophisticated, high net worth

entities may choose to conduct business through less well capitalized

affiliates or subsidiaries for a variety of reasons. Accordingly, it is

modifying the interim rule to permit a party to qualify for the

exemption on the strength of a guarantee by its affiliate which does

meet the net-worth requirement.

E. Relief for Exchange-Traded Instruments

Representatives of several futures and option exchanges expressed

the concern that lifting the ban on agricultural trade options would

put the exchanges at a competitive disadvantage. In commenting on the

advance notice, an exchange official noted that futures exchanges

currently are prohibited from offering options on physicals for these

same commodities,\34\ thereby restricting their ability to offer

certain flexible exchange-traded instruments and to compete with

agricultural trade options.\35\

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\34\ Commission rule 33.4 provides in part that ``[t]he

Commission may designate any board of trade located in the United

States as a contract market for the trading of * * * options on

physicals in any commodity regulated under the Act other than those

commodities which are specifically enumerated in section 1a(3) of

the Act * * *''

\35\ Flex options on futures on the enumerated agriculture

commodities have recently been proposed by exchanges and approved by

the Commission under current rules. These options are flexible in

terms of strike prices, last trading days, the underlying futures

months, and the style of exercise--American or European. Additional

types of flexible terms involving physical delivery would be

permitted if the Commission's rule is amended.

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The Commission agreed with the exchange commenter and proposed to

remove the restriction on exchange trading of options on physicals on

these commodities. A different exchange responded to this proposal,

labeling it a ``remarkably empty gesture.'' \36\ Whether or not the

exchanges choose to compete with physically-settled trade options by

offering flexible physically-settled option contracts, the Commission

believes that there is no longer a reason to preclude them from doing

so by regulation. Accordingly, it is removing the restriction for

exchange-traded

[[Page 18830]]

physically-settled agricultural contracts, as proposed.

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\36\ The exchange further complained that it ``is uncertain if

there is sufficient demand for exchange-trade[d] options on

physicals. In contrast, the present demand for our futures options

contracts is measurable, and the [exchange] is justifiably fearful

that the Commission's proposed pilot-program will adversely affect

such demand.'' Finally, the exchange notes that the Commission

unfairly holds the exchanges to higher regulatory standards than

proposed here and failed to include agricultural options within the

Part 36 pilot program.

Part 36 was promulgated by the Commission to initiate a pilot

program for less regulated exchange markets for professionals. No

futures exchange has listed a contract to trade pursuant to those

rules. Although the Commission did not include the agricultural

commodities in the pilot program initially, had the Part 36 pilot

program been successful, the Commission might have reconsidered its

scope as it did with the initial 1982 pilot program to introduce

exchange-traded options.

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IV. Other Matters

A. Paperwork Reduction Act (PRA)

When publishing final rules, the PRA of 1995 (Pub. L. 104-13 (May

13, 1995)) imposes certain requirements on federal agencies (including

the Commission) in connection with their conducting or sponsoring any

collection of information as defined by the PRA. In compliance with the

Act, these interim final rules inform the public of:

(1) the reasons the information is planned to be and/or has been

collected; (2) the way such information is planned to be and/or has

been used to further the proper performance of the functions of the

agency; (3) an estimate, to the extent practicable, of the average

burden of the collection (together with a request that the public

direct to the agency any comments concerning the accuracy of this

burden estimate and any suggestions for reducing this burden); (4)

whether responses to the collection of information are voluntary,

required to obtain or retain a benefit or mandatory; (5) the nature

and extent of confidentiality to be provided, if any; and (6) the

fact that an agency may not conduct or sponsor, and a person is not

required to respond to, a collection of information unless it

displays a currently valid OMB control number.''

The Commission previously submitted these rules in proposed form

and its associated information collection requirements to the Office of

Management and Budget (OMB). OMB approved the collection of information

associated with these rules on January 15, 1998 and assigned OMB

control number 3038-0048 to these rules. The burden associated with

this entire collection is as follows:

Average burden hours per response: 74.35.

Number of respondents: 3610.

Frequency of response: Daily.

Persons wishing to comment on the information required by these

interim final rules should contact the Desk Officer, CFTC, Office of

Management and Budget, Room 10202, NEOB, Washington, DC 20503, (202)

395-7340. Copies of the information collection submission to OMB are

available from the CFTC Clearance Officer, 1155 21st Street NW,

Washington, DC 20581, (202) 418-5160.

B. Regulatory Flexibility Act (RFA)

The RFA, 5 U.S.C. 601 et seq., requires that agencies consider the

impact of those rules on small businesses. The Commission has not

previously determined whether all or some agricultural trade option

merchants should be considered ``small entities'' for purposes of the

RFA and, if so, the economic impact on such entities. However, the

Commission is requiring as one of the conditions for registration as an

agricultural trade option merchant that the entity maintain a minimum

net worth of $50,000. The Commission previously found that other

entities which were required to maintain minimum levels of net capital

were not small entities for purposes of the RFA. See, 47 FR 18618,

18619 (April 30, 1982). The Commission has also found, however, that

one category of Commission registrant required to maintain a minimum

level of net capital--introducing brokers (IBs)--may include small

entities for purposes of the RFA.\37\ In addition to the $50,000

minimum net worth required for registration as an agricultural trade

option merchant, such registrants must be in business in the underlying

cash commodity so that they are able to take physical delivery on those

option contracts. This will require that they have additional resources

in order to qualify as an agricultural trade option merchant, in

contrast to an IB whose additional investment beyond the minimum net

capital may be relatively small. For this reason, the Commission

believes that agricultural trade option merchants are more

appropriately treated as not small entities under the RFA. Therefore,

the Chairperson, on behalf of the Commission, hereby certifies,

pursuant to 5 U.S.C. 605(b), that the action taken herein will not have

a significant economic impact on a substantial number of small

entities. This certification is based on the fact that the interim

final rules will remove a complete ban on the offer or sale of trade

options on the agricultural commodities enumerated under the Act. The

interim final rules permitting such transactions subject to the

specified conditions, therefore, remove a burden for all entities,

regardless of size.

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\37\ An IB is required to maintain adjusted net capital in the

amount of $30,000, unless it enters into a guarantee agreement with

an FCM. Most IBs operate pursuant to such an agreement. See, 61 FR

19177 (May 1, 1996).

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List of Subjects

17 CFR Part 3

Administrative practice and procedure, Brokers, Commodity futures.

17 CFR Part 32

Commodity futures, Commodity options, Prohibited transactions, and

Trade options.

17 CFR Part 33

Commodity futures, Consumer protection, Fraud.

In consideration of the foregoing, and pursuant to the authority

contained in the Act, and in particular sections 2(a)(1)(A), 4c, and

8a, 7 U.S.C. 2, 6c, and 12a, as amended, the Commission hereby amends

parts 3, 32, and 33 of chapter I of title 17 of the Code of Federal

Regulations as follows:

PART 3--REGISTRATION

1. The authority citation for part 3 continues to read as follows:

Authority: 7 U.S.C. 1a, 2, 4, 4a, 6, 6b, 6c, 6e, 6f, 6g, 6h, 6i,

6k, 6m, 6n, 6o, 6p, 8, 9, 9a, 12, 12a, 13b, 13c, 16a, 18, 19, 21,

23; 5 U.S.C. 552, 552b.

2. Part 3 is amended by adding new Secs. 3.13 and 3.14 to read as

follows:

Sec. 3.13 Registration of agricultural trade option merchants and

their associated persons.

(a) Definitions. (1) Agricultural trade option merchant.

``Agricultural trade option merchant'' means any person that is in the

business of soliciting, offering to enter into, entering into,

confirming the execution of, or maintaining a position in, transactions

or agreements in interstate commerce which are not conducted or

executed on or subject to the rules of a contract market, and which are

or are held out to be of the character of, or are commonly known to the

trade as, an ``option,'' ``privilege,'' ``indemnity,'' ``bid,''

``offer,'' ``put,'' ``call,'' ``advance guarantee,'' or ``decline

guarantee,'' involving wheat, cotton, rice, corn, oats, barley, rye,

flaxseed, grain sorghums, mill feeds, butter, eggs, solanum tuberosum

(Irish potatoes), wool, wool tops, fats and oils (including lard,

tallow, cottonseed oil, peanut oil, soybean oil and all other fats and

oils), cottonseed meal, cottonseed, peanuts, soybeans, soybean meal,

livestock, livestock products, and frozen concentrated orange juice.

Provided, however, that any person entering into such transactions

solely for the purpose of managing the risk arising from the conduct of

his or her own commercial enterprise is not considered to be in the

business described in this paragraph.

(2) Associated person of an agricultural trade option merchant.

``Associated person of an agricultural trade option merchant'' means a

partner, employee, or agent (or any person occupying a similar status

or performing similar functions) that:

(i) Solicits or accepts customers' orders (other than in a clerical

capacity) or

[[Page 18831]]

(ii) Supervises any person or persons so engaged.

(b) Registration required. It shall be unlawful for any person in

the business of soliciting, offering or selling the instruments listed

in Sec. 32.2 of this chapter to solicit, to offer to enter into, or to

enter into, to confirm the execution of, or to maintain transactions in

such instruments or to supervise persons so engaged except if

registered as an agricultural trade option merchant or as an associated

person of such a registered agricultural trade option merchant under

this section.

(c) Duration of registration. (1) A person registered in accordance

with the provisions of this section shall continue to be registered

until the revocation or withdrawal of registration.

(2) Agricultural trade option merchants must notify the National

Futures Association within twenty days when an associated person has

ceased to be so associated.

(3) An associated person who ceases to be associated with a

registered agricultural trade option merchant is prohibited from

engaging in activities requiring registration under Sec. 32.13 of this

chapter or representing himself or herself to be a registrant until:

(i) A registered agricultural trade option merchant notifies the

National Futures Association of the person's association; and

(ii) The associated person certifies to the National Futures

Association that he or she is not disqualified from registration for

the reasons listed in section 8a(2) and (3) of the Act; Provided

however, no such certification is required when the associated person

becomes associated with the new agricultural trade option merchant

within ninety days from when the associated person ceased the previous

association.

(d) Conditions for registration. (1) Applicants for registration as

an agricultural trade option merchant must meet the following

conditions:

(i) The agricultural trade option merchant must have and maintain

at all times net worth of at least $50,000 computed in accordance with

generally accepted accounting principles;

(ii) The agricultural trade option merchant must identify each of

the natural persons who are the agricultural trade option merchant's

principals, as defined in Sec. 3.1(a), and for any principal which is a

non-natural person, each natural person who is the holder or beneficial

owner of ten percent or more of the outstanding shares of any class of

stock or has contributed ten percent or more of the capital of the

entity that is principal;

(iii) Each of the natural persons identified in paragraph (d)(1) of

this section must certify that he or she is not disqualified from

registration for the reasons listed in section 8a(2) and (3) of the

Act;

(iv) The agricultural trade option merchant must certify that to

the best of its knowledge, information and belief each of its

associated persons or persons it intends to employ as an associated

person within thirty days of that person's registration meets the

requirements for registration as such; and

(v) The agricultural trade option merchant must provide access to

any representative of the Commission or the U.S. Department of Justice

for the purpose of inspecting books and records.

(2) Applicants for registration as an associated person of an

agricultural trade option merchant must meet the following conditions.

Such persons must:

(i) Identify the agricultural trade option merchant with whom the

person is associated or to be associated within thirty days of the

person's registration;

(ii) Certify that he or she is not disqualified from registration

for the reasons listed in section 8a(2) and (3) of the Act; and

(iii) Complete six hours of instruction in the requirements of the

Act and rules promulgated thereunder, the economic functioning and

risks of the transactions permitted in Sec. 32.13 of this chapter, and

the registrant's responsibility to observe just and equitable

principles of trade relating to such transactions. Such instruction can

be by classroom, videotape or electronic presentation.

(e) Applications for registration. (1) The agricultural trade

option merchant including its principals and associated persons of an

agricultural trade option merchant must apply for registration on the

appropriate forms specified by the National Futures Association and

approved by the Commission, in accordance with the instructions

thereto, including the separate certifications from each natural person

that he or she is not disqualified for any of the reasons listed in

section 8a(2) and (3) of the Act and such other identifying background

information as may be specified.

(2) The agricultural trade option merchant's application must also

include its most recent annual financial statements certified by an

independent certified public accountant in accordance with generally

accepted auditing standards prepared within the prior 12 months.

(3) An associated person's application must also include written

evidence from the person providing the instruction that the applicant

completed the six hours of instruction required by paragraph

(d)(2)(iii) of this section.

(4) These applications must be supplemented to include any changes

in the information required to be provided thereon on a form specified

by the National Futures Association and approved by the Commission.

(f) Withdrawal of application for registration; denial, suspension

and revocation of registration. The provisions of Secs. 3.51, 3.55,

3.56 and 3.60 shall apply to applicants for registration and

registrants as agricultural trade options merchants and their

associated persons under this part 3 as though they were an applicant

or registrant in any capacity under the Act.

(g) Withdrawal from registration. An agricultural trade option

merchant that has ceased or has not commenced engaging in activities

requiring registration may withdraw from registration 30 days after

notifying the National Futures Association on the specified form of its

intent to do so, unless otherwise notified by the National Futures

Association or by the Commission. Such a withdrawal notification must

include information identifying the location of, and the custodian

authorized to release, the agricultural trade option merchant's

records, a statement of the disposition of customer positions, cash

balances, securities or other property and a statement that no

obligations to customers arising from agricultural trade options remain

outstanding.

(h) Dual registration of associated persons. An associated person

of an agricultural trade option merchant may be associated with other

registrants subject to the provisions of Sec. 3.12(f).

Sec. 3.14 Requirements for trainers of associated persons of

agricultural trade option merchants.

(a) A person offering instruction or preparing an instructional

videotape or electronic presentation under this section must meet the

following conditions:

(1) Has a minimum of three years of relevant experience; and

(2) Is not subject to:

(i) Statutory disqualification from registration under section

8a(2) and (3) of the Act;

(ii) A bar from service on self-regulatory organization governing

boards or committees based on disciplinary history pursuant to

Sec. 1.63

[[Page 18832]]

of this chapter or any self-regulatory organization rule adopted

thereunder; or

(iii) A pending adjudicatory proceeding under sections 6(c), 6(d),

6c, 6d or 9 of the Act or similar proceeding under section 8a of the

Act or Secs. 3.55, 3.56 or 3.60.

(b) Persons offering instruction or preparing an instructional

videotape or electronic presentation under this section must provide

written evidence of completion of the six hours of instruction required

under Sec. 3.13 to those completing this instruction. The written

evidence of completion must include:

(1) A certification that the person offering the instruction meets

the conditions of paragraph (a) of this section; and

(2) A disclaimer which reads: ``The content, quality or accuracy of

this training program has not been passed upon or endorsed by the

Commodity Futures Trading Commission or the National Futures

Association.''

(c) Before offering such training, a person must notify the

National Futures Association of the intention to do so, provide a

certification to the National Futures Association that the person

offering such training meets the requirements of each condition of

paragraph (a) of this section, and notify the National Futures

Association of any subsequent changes in circumstances which would make

the certification inaccurate.

(d) Persons offering instruction or preparing an instructional

videotape or electronic presentation under this section must maintain

in accordance with Sec. 1.31 of this chapter documentation reasonably

designed to verify the completion of this training by persons taking

instruction.

(e) Persons offering instruction or preparing an instructional

videotape or electronic presentation under this section may not

represent or imply in any manner whatsoever that the person has been

sponsored, recommended or approved, or that such person's abilities or

qualification, or the content, quality or accuracy of the person's

instructional program have in any respect been passed upon or endorsed,

by the Commission or the National Futures Association.

PART 32--REGULATION OF COMMODITY OPTION TRANSACTIONS.

3. The authority citation for part 32 continues to read as follows:

Authority: 7 U.S.C. 2, 6c and 12a.

4. Section 32.2 is revised to read as follows:

Sec. 32.2 Prohibited transactions.

Notwithstanding the provisions of Sec. 32.11, no person may offer

to enter into, confirm the execution of, or maintain a position in, any

transaction in interstate commerce involving wheat, cotton, rice, corn,

oats, barley, rye, flaxseed, grain sorghums, mill feeds, butter, eggs,

solanum tuberosum (Irish potatoes), wool, wool tops, fats and oils

(including lard, tallow, cottonseed oil, peanut oil, soybean oil and

all other fats and oils), cottonseed meal, cottonseed, peanuts,

soybeans, soybean meal, livestock, livestock products, and frozen

concentrated orange juice if the transaction is or is held out to be of

the character of, or is commonly known to the trade as an ``option,''

``privilege,'' ``indemnity,'' ``bid,'' ``offer,'' ``put,'' ``call,''

``advance guarantee,'' or ``decline guarantee,'' except as provided

under Sec. 32.13 of this part.

5. New Sec. 32.13 is added to part 32 to read as follows:

Sec. 32.13 Exemption from prohibition of commodity option transactions

for trade options on certain agricultural commodities.

(a) The provisions of Sec. 32.11 shall not apply to the

solicitation or acceptance of orders for, or the acceptance of money,

securities or property in connection with, the purchase or sale of any

commodity option on a physical commodity listed in Sec. 32.2 by a

person who is a producer, processor, or commercial user of, or a

merchant handling, the commodity which is the subject of the commodity

option transaction, or the products or byproducts thereof, if all of

the following conditions are met at the time of the solicitation or

acceptance:

(1) That person is registered with the Commission as an

agricultural trade option merchant and that person's associated persons

and their supervisors are registered as associated persons of an

agricultural trade option merchant under Sec. 3.13 of this chapter.

(2) The option offered by the agricultural trade option merchant is

offered to a producer, processor, or commercial user of, or a merchant

handling, the commodity which is the subject of the commodity option

transaction, or the products or byproducts thereof, and such producer,

processor, commercial user, or merchant is offered or enters into the

commodity option transaction solely for purposes related to its

business as such.

(3) The option cannot be off-set and, if exercised, must result in

physical delivery of the underlying commodity; Provided, however, that

nothing in this paragraph precludes amendment of the option contract's

delivery date or the substitution of a forward contract agreement for

the option contract prior to the option's expiration or exercise.

(4) To the extent that payment by the customer of the purchase

price is made to the agricultural trade option merchant prior to option

expiration or exercise, that amount:

(i) May only be used by the agricultural trade option merchant to

purchase a covering position on a contract market designated under

section 6 of the Act or part 33 of this chapter; and

(ii) Any amount not so used, shall be treated as belonging to the

customer until option expiration or exercise as provided under

Sec. 32.6, provided, however, that notwithstanding the last proviso of

Sec. 32.6(a), the full amount of such payment shall be treated as

belonging to the option customer.

(5) Producers may not:

(i) Grant or sell a put option; or

(ii) Grant or sell a call option, except to the extent that such a

call option is purchased or combined with a purchased or long put

option position, and only to the extent that the customer's call option

position does not exceed the customer's put option position in the

amount to be delivered. Provided, however, that the options must be

entered into simultaneously and expire simultaneously or at any time

that one or the other option is exercised.

(6) All option contracts, including all terms and conditions,

offered or sold pursuant to this section shall be in writing, an

executed copy of which shall be provided to the customer, and shall

contain terms relating to the following:

(i) The procedure for exercise of the option contract, including

the expiration date and latest time on that date for exercise;

(ii) The strike price(s) of the option contract;

(iii) The total quantity of commodity underlying the option

contract;

(iv) The quality or grade of commodity to be delivered if the

contract is exercised and any adjustments to price for deviations from

stated quality or grade, or the range of, and a statement of the method

for calculating, such adjustments;

(v) The delivery location if the contract is exercised;

(vi) The separate elements comprising the purchase price to be

charged, including the premium, mark-ups on the premium, costs, fees

and other charges; and

(vii) The additional costs, if any, in addition to the purchase

price which

[[Page 18833]]

may be incurred by an option customer if the commodity option is

exercised, including, but not limited to, the amount of storage fees,

interest, commissions (whether denominated as sales commissions or

otherwise) and all similar fees and charges which may be incurred.

(7) Prior to the entry by a customer into the first option

transaction with an agricultural trade option merchant, the

agricultural trade option merchant shall furnish, through written or

electronic media, a summary disclosure statement to the option

customer. The summary disclosure statement shall include:

(i) The following statements in boldface type on the first page(s)

of the summary disclosure statement:

This brief statement does not disclose all of the risks and

other significant aspects of trading in commodity trade options. You

are encouraged to seek out as much information as possible from

sources other than the person selling you this option about the use

and risks of option contracts before entering into this contract.

The issuer of your option should be willing and able to answer

clearly any of your questions.

Appropriateness of Option Contracts

Option contracts may result in the total loss of any funds you

pay to the issuer of your option. You should carefully consider

whether trading in such instruments is appropriate for you in light

of your experience, objectives, financial resources and other

relevant circumstances. The issuer of your option contract should be

willing and able to explain the financial outcome of your option

contract under all market conditions. You should also be aware that

you may be able to obtain a similar contract or execute a similar

risk management strategy using an instrument traded on a futures

exchange which offers greater regulatory and financial protections.

Costs and Fees Associated With an Option Contract

Before entering into an option contract, you should understand

all of the costs and obligations associated with your option

contract. These include the option premium, commissions, fees, costs

associated with delivery if the option is exercised and any other

charges which may be incurred. All of these costs and fees must be

specified in the terms of your option contract and must be explained

in the transaction disclosure statement.

Business Use of Trade Options

In order to comply with the law, you must be buying this option

for business-related purposes. The terms and structure of the

contracts must therefore relate to your activity or commitments in

the underlying cash market. If a trade option is exercised, delivery

of the commodity must occur. Any amendments allowed to the option

contract must reflect changes in your activity, in your commitments

in the underlying cash market or in the carrying of inventory.

Produces are not permitted to enter into short call options unless

the producer is also entering into a long put option contract for

the same amount or more of the commodity, at the same time and with

the same expiration date. Producers are not permitted to sell put

options, whether alone or in combination with a call option.

Dispute Resolution

If a dispute should arise under the terms of this trade option

contract, you have the right to choose to use the reparations

program run by the Commodity Futures Trading Commission or any other

dispute resolution forum provided to you under the terms of your

customer agreement or by law. For more information on the

Commission's Reparations Program contact: Office of Proceedings,

Commodity Futures Trading Commission, Three Lafayette Centre, 1155

21st Street, NW., Washington, DC 20581, (202) 418-5250.

Acknowledgement of Receipt

The Commodity Futures Trading Commission requires that all

customers receive and acknowledge receipt of this disclosure

statement. The Commodity Futures Trading Commission does not intend

this statement as a recommendation or endorsement of agricultural

trade options. These commodity options have not been approved or

disapproved by the Commodity Futures Trading Commission, nor has the

Commission passed upon the accuracy or adequacy of this disclosure

statement. Any representation to the contrary is a violation of the

Commodity Exchange Act and Federal regulations.

(ii) The following acknowledgment section:

I hereby acknowledge that I have received and understood this

summary risk disclosure statement.

----------------------------------------------------------------------

Date

----------------------------------------------------------------------

Signature of Customer

(8) Prior to entry by a customer into each option transaction with

an agricultural trade option merchant, the agricultural trade option

merchant shall furnish, through written or electronic media, a

transaction disclosure statement to the option customer. The

transaction disclosure statement shall include the following

information:

(i) The procedure for exercise of the option contract, including

the expiration date and latest time on that date for exercise;

(ii) A description of the elements comprising the purchase price to

be charged, including the premium, mark-ups on the premium, costs, fees

and other charges, and the services to be provided for the separate

elements comprising the purchase price;

(iii) A description of any and all costs in addition to the

purchase price which may be incurred by an option customer if the

commodity option is exercised, including, but not limited to, the

amount of storage fees, interest, commissions (whether denominated as

sales commissions or otherwise) and all similar fees and charges which

may be incurred;

(iv) Where the full option premium or purchase price of the option

is not collected up front or where through amendments to the option

contract it is possible to lose more than the amount of the initial

purchase price of the option, a description of the worst possible

financial outcome on the contract that could be suffered by the

customer; and

(v) The following acknowledgment section:

I hereby acknowledge that I have received and understood this

transaction risk disclosure statement.

----------------------------------------------------------------------

Date

----------------------------------------------------------------------

Signature of Customer

(b) Report of account information. Registered agricultural trade

option merchants must provide customers with open positions the

following information:

(1) Within 24 hours of execution of an agricultural trade option,

written confirmation of the transaction, including an executed copy of

the written contract and all information required in paragraph (a)(6)

of this section;

(2) Within 24 hours of a request by the customer, or 48 hours of a

request for a response in writing, current commodity price quotes, all

other information relevant to the customer's position or account, and

the amount of any funds owed by, or to, the customer;

(3) Written notice of the expiration date of each option which will

expire within the subsequent calendar month.

(c) Recordkeeping. Registered agricultural trade option merchants

shall keep full, complete and systematic books and records together

with all pertinent data and memoranda of or relating to such

transactions, including customer solicitations and covering

transactions, maintain such books and records as specified in Sec. 1.31

of this chapter, and make such reports to the Commission as provided

for in paragraphs (c) and (d) of this section and as the Commission may

otherwise require by rule, regulation, or order. Such books and records

shall be open at all times to inspection by any representative of the

Commission and the United States Department of Justice.

(d) Reports. Registered agricultural trade option merchants must

file reports quarterly with the National Futures Association, in the

form and manner

[[Page 18834]]

specified by the National Futures Association and approved by the

Commission, which shall contain the following information:

(1) By commodity and put, call or combined option:

(i) Total number of new contracts entered into during the reporting

period;

(ii) Total quantity of commodity underlying new contracts entered

into during the reporting period;

(iii) Total number of contracts outstanding at the end of the

reporting period;

(iv) Total quantity of underlying commodity outstanding under

option contracts at the end of the reporting period;

(v) Total number of options exercised during the reporting period;

and

(vi) Total quantity of commodity underlying the exercise of options

during the reporting period.

(2) Total number of customers by commodity with open option

contracts at the end of the reporting period.

(e) Special calls. Upon special call by the Commission for

information relating to agricultural trade options offered or sold on

the dates specified in the call, each agricultural trade option

merchant shall furnish to the Commission within the time specified the

following information as specified in the call:

(1) All positions and transactions in agricultural trade options

including information on the identity of agricultural trade option

customers and on the value of premiums, fees, commissions, or charges

other than option premiums, collected on such transactions.

(2) All related positions and transactions for future delivery or

options on contracts for future delivery or on physicals on all

contract markets.

(3) All related positions and transactions in cash commodities,

their products, and by-products.

(f) Internal controls. (1) Each agricultural trade option merchant

registered with the Commission shall prepare, maintain and preserve

information relating to its written policies, procedures, or systems

concerning the agricultural trade option merchant's internal controls

with respect to market risk, credit risk, and other risks created by

the agricultural trade option merchant's activities, including systems

and policies for supervising, monitoring, reporting and reviewing

trading activities in agricultural trade options; policies for hedging

or managing risk created by trading activities in agricultural trade

options, including a description of the types of reviews conducted to

monitor positions; and policies relating to restrictions or limitations

on trading activities.

(2) The financial statements of the agricultural trade option

merchant must on an annual basis be audited by a certified public

accountant in accordance with generally accepted auditing standards.

(3) The agricultural trade option merchant must file with the

Commission a copy of its certified financial statements within 90 days

after the close of the agricultural trade option merchant's fiscal

year.

(4) The agricultural trade option merchant must perform a

reconciliation of its books at least monthly.

(5) The agricultural trade option merchant:

(i) Must report immediately if its net worth falls below the level

prescribed in Sec. 3.13(d)(i) of this chapter and must report within

three days discovery of a material inadequacy in its financial

statements by an independent public accountant or any state or federal

agency performing an audit of its financial statements to the

Commission and National Futures Association by facsimile, telegraphic

or other similar electronic notice; and

(ii) Within five business days after giving such notice, the

agricultural trade option merchant must file a written report with the

Commission stating what steps have been taken or are being taken to

correct the material inadequacy.

(6) If the agricultural trade option merchant's net worth falls

below the level prescribed in Sec. 3.13(d)(i) of this chapter, it must

immediately cease offering or entering into new option transactions and

must notify customers having premiums which the agricultural trade

option merchant is holding under paragraph (a)(4) of this section that

such customers can obtain an immediate refund of that premium amount,

thereby closing the option position.

(g) Exemption. (1) The provisions of Secs. 3.13, 32.2, 32.11 and

this section shall not apply to a commodity option offered by a person

which has a reasonable basis to believe that:

(i) The option is offered to a producer, processor, or commercial

user of, or a merchant handling, the commodity which is the subject of

the commodity option transaction, or the products or byproducts

thereof;

(ii) Such producer, processor, commercial user or merchant is

offered or enters into the commodity option transaction solely for

purposes related to its business as such; and

(iii) Each party to the option contract has a net worth of not less

than $10 million or the party's obligations on the option are

guaranteed by a person which has a net worth of $10 million and has a

majority ownership interest in, is owned by, or under common ownership

with, the party to the option.

(2) Provided, however, that Sec. 32.9 continues to apply to such

option transactions.

PART 33--REGULATION OF DOMESTIC EXCHANGE-TRADED COMMODITY OPTION

TRANSACTIONS

6. The authority citation for part 33 continues to read as follows:

Authority: 7 U.S.C. 1a, 2, 4, 6, 6a, 6d, 6e, 6f, 6g, 6h, 6i, 6j,

6k, 6l, 6m, 6n, 6o, 7, 7a, 7b, 8, 9, 11, 12a, 13a, 13a-1, 13b, 19,

and 21.

7. The first sentence of the introductory text of Sec. 33.4 is

revised to read as follows:

Sec. 33.4 Designation as a contract market for the trading of

commodity options.

The Commission may designate any board of trade located in the

United States as a contract market for the trading of options on

contracts of sale for future delivery or for options on physicals in

any commodity regulated under the Act, when the applicant complies with

and carries out the requirements of the Act (as provided in Sec. 33.2),

the regulations in this part, and the following conditions and

requirements with respect to the commodity option for which the

designation is sought:

* * * * *

Issued this 8th day of April, 1998, in Washington, D.C., by the

Commodity Futures Trading Commission.

Jean A. Webb,

Secretary of the Commission.

Concurring Remarks of Commissioner David D. Spears on Trade Options on

the Enumerated Agricultural Commodities

I respectfully concur with my colleagues on the promulgation of

interim final rules that permit the offer and sale of agricultural

trade options off-exchange between commercial users, subject to

certain regulatory conditions. I am pleased to say that the interim

rules reflect a significant improvement from the proposed rules of

November 4, 1997. I think that the industry will agree that the

rules are more streamlined and impose less regulatory conditions

than the rules as proposed in November.

Nevertheless, in seeking to strike the balance between

reasonable regulation and undue regulatory burdens, I am of the view

that the interim rules remain somewhat restrictive in certain

respects. Therefore, I would encourage the Commission to review, at

least on an annual basis, the progress of the agricultural trade

option pilot program and to pay careful attention to the program's

regulatory provisions to assess their usefulness and necessity.

[[Page 18835]]

In making its reviews of the pilot program, the Commission

should focus specific attention on the restrictions imposed on

option contract design and strategies. The success of risk

management tools is partly dependent upon the ability of users to

tailor contracts to meet specific business concerns. The Commission

has made some changes from its proposed rules to provide additional

flexibility in contract design. However, the pilot program should

afford participants even greater flexibility to negotiate specific

contract terms and strategies, subject only to general guidelines.

In addition, the $10 million net worth requirement necessary to

trigger an exemption from the regulations should be scrutinized more

closely. My view is that there may be a more appropriate net worth

level at which to set exemption eligibility. I therefore would

recommend a reconsideration of the net worth amount within one year

following the effective date of the interim rules, if not sooner.

Finally, I believe we have made significant progress towards

transforming the November proposal into a less complex, shorter and

more workable program. The fact that the program is, by its terms, a

pilot program, provides the Commission and the industry with an

opportunity to address individual situations that arise in the

marketplace. To this end, I am hopeful that the agricultural

community, the futures exchanges and others involved in the futures

industry will remain in close contact with the Commission during the

interim period. It is important that we maintain open lines of

communication and that the Commission is apprised of the needs of

the private sector. In this manner, adjustments to the pilot program

may be made, as appropriate.

Dated: April 7, 1998.

David D. Spears.

Commissioner.

Concurring Remarks of Commissioner Barbara Pedersen Holum, Interim

Final Rules, Trade Options on the Enumerated Agricultural Commodities

I agree with and join in the action the Commission is taking to

permit exchange trading of options on physicals on the enumerated

agricultural commodities. In particular, I believe this important

initiative recognizes the potential of exchanges in offering more

flexible option contracts. Exchanges in the past have demonstrated

an exceptional ability to meet the demands of the market. I am

therefore confident, now that the prohibition is to be lifted, the

exchanges will work with the end-users to develop option contracts

with the necessary flexibility to meet their individualized needs.

While I also join in the Commission's lifting of the prohibition

on the offer and sale of off-exchange trade options on the

enumerated agricultural commodities, I have serious concerns about

the extensive regulatory provisions included in the interim rules.

Specifically, these interim rules create a regulatory infrastructure

essentially duplicating that which already exists on the exchanges.

While the Commission has acted to exempt other off-exchange

transactions from much of the centralized regulatory structure,

these interim rules impose new, extensive, and costly regulatory

mandates. In my opinion, the imposition of this far-reaching

regulatory structure, and its additional costs, will limit

participation and deny producers and processors the very risk

management tools that lifting the ban envisions.

Dated: April 8, 1998.

Barbara Pedersen Holum,

Commissioner.

[FR Doc. 98-9879 Filed 4-15-98; 8:45 am]

BILLING CODE 6351-01-M