Paper Tiger: the validity of CFTC position-limit rulemaking under Dodd-Frank.

Author:Notini, Andrew
Position:Commodity Futures Trading Commission

"Indeed, the Commission has a unique obligation to consider the effect of a new rule upon 'efficiency, competition, and capital formation,' and its failure to 'apprise itself---and hence the public and the Congress--of the economic consequences of a proposed regulation' makes promulgation of the rule arbitrary and capricious and not in accordance with law." (1)


    The passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), signed into law by President Barack Obama on July 21, 2010, was Congress's response to the 2007 global financial crisis. (2) This crisis was primarily caused by the inflation of the housing bubble along with financial institutions' risky mortgage lending and securitization practices, leading to a severe liquidity strain and credit crunch among these institutions and a near collapse of the global financial system. (3) Preceding these events was a period of laissez-faire financial regulation wherein major financial institutions and capital markets were largely left to regulate themselves. (4) The passage of Dodd-Frank marked a return to strict governmental regulation of both capital markets and large financial institutions for the purpose of re-establishing the financial stability of the United States. (5)

    The implementation of Dodd-Frank was left to the regulatory power of federal agencies such as the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC or Commission). (6) The National Securities Markets Improvement Act of 1996 (NSMIA) had previously helped to define the boundaries of this rulemaking power by requiring the SEC to consider the "promotion of efficiency, competition, and capital formation" when formulating regulations. (7) As will be discussed in Part II.B.1, this requirement means that a rulemaking agency must perform a thorough cost-benefit analysis of every regulation it makes, support its predictions, and respond to public concerns about the proposed regulation. (8) Regulations failing to live up to this standard are not likely to survive judicial challenge after being deemed "arbitrary and capricious and not in accordance with law." (9)

    Recently, courts have struck down the validity of certain SEC regulations when taking the cost-benefit-analysis rule into consideration. (10) of particular interest to the financial community has been the Supreme Court's decision in Business Roundtable v. SEC, in which the Court struck down an SEC "proxy access" regulation because the SEC failed to undertake a sufficient cost-benefit analysis and justification. (11) In light of this decision, many industry groups have been exploring the possibility of challenging other SEC and CFTC regulations promulgated in response to Dodd-Frank including speculative-trading limits, capital and margin requirements for uncleared swaps, real-time swap trade reporting, incentive-based compensation requirements, and conflict-minerals disclosure. (12) This activity has caused concern in the regulatory community and has spurred the SEC and CFTC to attempt to bolster their regulations to withstand similar legal challenges. (13)

    The purpose of this Note is to evaluate the effect of recent decisions, especially Business Roundtable, on court challenges to the CFTC regulation concerning position limits for commodity futures and derivatives. Part II.A will briefly discuss the recent history of financial regulation in the United States before exploring the economic circumstances that led to the passage of Dodd-Frank. (14) Part II.B will discuss the implementation of the Dodd-Frank Act and other legislation that both bolstered and limited the regulatory power of the SEC and CFTC. (15) Part II.B will also spell out the aforementioned CFTC regulations, including their cost-benefit analysis and justification along with concerns voiced by members of the financial community whom the regulations will affect. (16) Additionally, Part II.B will explore the recent district court decision remanding the position-limit rule back to the CFTC for further consideration. (17) Part II.C will dissect relevant court decisions that have invalidated SEC regulations. (18) Finally, Part III compares the proposed CFTC regulations with those defeated in the courts, and attempts to predict the success or failure of the promulgated rules in a court challenge. (19)


    1. Regulatory and Economic Framework

      1. Recent History of U.S. Financial Regulation Leading to Dodd-Frank

        Currently, securities transactions in the United States are governed by both federal and state law. (20) Prior to 1996, states used "blue sky laws" to regulate the securities industry, as long as federal laws did not preempt the state law. (21) However, in 1996, Congress passed the NSMIA, preempting certain blue-sky laws that had previously coexisted with federal regulation and leaving federal law as the premier governing law of securities transactions. (22)

        In the years leading up to the 2007 global financial crisis, the U.S. government weakened its regulatory oversight in the hope that markets would self-regulate and self-correct, evidencing a large shift in the financial regulatory system. (23) This self-corrective theory was predicated on the rationale that too much regulation was hampering the competitiveness of U.S. markets. (24) This attitude was largely based on the erosion of the gap between investment banking and commercial banking imposed by the Glass-Steagall Act, culminating in the 1999 Financial Services Modernization Act, which revoked Glass-Steagall's separation provision. (25) As a result, the government adopted a functional approach to financial regulation where the Federal Reserve (Fed) regulated the commercial-banking functions of a financial company and the SEC regulated the investment-banking functions of that same company. (26) Ultimately, this scheme provided the opportunity for abuse across investment-and commercial-banking functions because no regulator had the authority to address the entire system. (27)

        Congress has granted broad rulemaking power to regulatory agencies like the SEC and the CFTC. (28) In 1974, Con gress created the CFTC by amending the 1936 Commodity Exchange Act (CEA) and gave it the exclusive jurisdiction to regulate commodity-based futures and options. (29) The Commodity Futures Modernization Act of 2000 (CFMA) clarified the SEC's and CFTC's authority to regulate certain types of derivatives and ultimately exempted all over-the-counter (OTC) derivatives, leaving the market largely unregulated. (30) Absent regulation, the size of the OTC derivatives market swelled and company exposure to large OTC derivative positions became a leading cause of the 2007 financial crisis. (31)

      2. Economic Circumstances Leading to the 2007 Financial Crisis

        Congress passed Dodd-Frank in response to the 2007 financial crisis. (32) The crisis was primarily caused by massive, widespread defaults on subprime mortgage loans that were packaged into securities and sold in large quantities to global institutional investors. (33) Low interest rates encouraged Americans to borrow excessively for home mortgages between 2001 and 2004. (34) In 2004, the Fed began to raise interest rates and, as a result, subprime mortgages became unmanageable as the borrowers could no longer afford to make their monthly payments. (35) Spurred by increasing foreclosures, valuations of mortgage-based assets held by financial institutions (some supported by Fannie-Mae and Freddie-Mac and insured by American International Group) began to crash in 2007. (36)

        Aside from economic factors, regulatory failings also shared the blame for the crisis. (37) Financial engineering and innovation created more sophisticated financial instruments leading to misunderstanding of risk and investor losses. (38) These sophisticated financial instruments were difficult to regulate because of the fragmented regulatory system, shielding new financial products such as OTC derivatives from the eyes of regulators and allowing for abuses in underwriting and exposure. (39) The regulatory situation deteriorated when the SEC allowed large investment banks to double their asset-to-capital ratio to more than thirty-to-one. (40) As losses on mortgage-backed securities mounted, they began to consume what little capital the banks had left, creating a liquidity crisis among large Wall Street Banks and negatively affecting global stock markets. (41)

    2. Position-Limit Rule and Relevant Legislation

      1. Effect of NSMIA on Rulemaking Guidelines

        Section 106 of the NSMIA amends the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Company Act of 1940. (42) The amendments require that financial rulemakers, such as the SEC and CFTC, determine whether an action is necessary or appropriate to the public interest. (43) In addition, rulemakers should consider whether the action will promote efficiency, competition, and capital formulation. (44) Support for this legislation among lawmakers stemmed from a belief that the removal of antiquated and inefficient regulations would clear impediments to financial innovation, efficiency, and capital formation. (45) Further, lawmakers intended for this legislation to require financial rulemakers to undergo a cost analysis of their proposed rules before enacting them, in order to achieve this efficiency. (46) In the event that an agency action is challenged in court for failure to consider such analysis, the reviewing court may set aside the regulation if it is "arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law." (47)

      2. Purpose and Implementation of Dodd-Frank

        Dodd-Frank, signed into law on July 21, 2010, covers nearly all aspects of financial regulation and calls for a significant amount of discretionary rulemaking by the SEC and CFTC. (48) In the wake of the crisis, President Obama outlined seven broad principles to guide...

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