Derivatives Firms' Preservation Obligations During COVID-19

By David Slovick and Trace Schmeltz
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Law360 (August 25, 2020, 5:38 PM EDT) --
David Slovick
David Slovick
Trace Schmeltz
Trace Schmeltz
While in-person client lunches and out-of-town professional seminars may be off limits for the time being, the videoconference has done a reasonably good job in recent months of filling the void.

Like them or not, Zoom meetings, Webex presentations and Skype check-ins accomplish most of what we need from our face-to-face interactions with clients and colleagues. But do they bring with them unintended regulatory obligations?

Regulatory agencies have long required the entities they regulate to keep records of the transactions they engage in for their clients. A recent iteration of this requirement is the rule passed by the U.S. Commodity Futures Trading Commission less than a decade ago that requires certain registrants to keep recordings of telephone calls between the firm and its clients.

The National Futures Association has similar rules governing the preservation of promotional materials transmitted by video, the internet and other electronic media.

Although these rules were not necessarily adopted with videoconferencing in mind, at first glance they appear to require you to record the Zoom meeting you scheduled with your best customer next week. Analysis of these rules demonstrates, however, that the only communications that need to be recorded are those relating to:

  • "[Q]uotes, solicitations, bids, offers, instructions, trading, and prices," from CFTC Rule 1.35; or
  • "[A] commodity interest account, agreement or transaction," from NFA Rule 2-29.

As a result, having a written supervisory provision in place providing for employee training around constraining use of such tools to high-level, nonbusiness-soliciting communications and some supervision — such as spot checks by supervisors or attendance at presentations hosted by Zoom or similar tools by supervisory personnel — should allow you to conduct business without having to record each and every technology-assisted meeting.

The Obligation to Preserve Client Communications: CFTC Rule 1.35

As part of its rulemaking under the Dodd-Frank Act, on Feb. 19, 2013, the CFTC enacted Rule 1.35, which requires futures commission merchants, introducing brokers and other participants in the derivatives markets to record certain electronic communications directed to or received from their clients. In the section of the CFTC's adopting release discussing the purpose of the new rule, the CFTC explained that:

[r]equiring the recording and retention of oral communications will serve as a disincentive for covered entities to make fraudulent or misleading communications to their customers over the telephone and could serve as a meaningful deterrent against violations such as trading ahead of customer orders by providing a record of the time that a customer's telephone order is received.[1]

To achieve this deterrent effect, Rule 1.35 sweeps broadly to encompass all forms of "digital or electronic media" that could be used to transmit client communications. In relevant part, Rule 1.35 provides:

Each futures commission merchant, retail foreign exchange dealer, and introducing broker that has generated over the preceding three years more than $5 million in aggregate gross revenues from its activities as an introducing broker, shall ... [k]eep all oral and written communications provided or received concerning quotes, solicitations, bids, offers, instructions, trading, and prices that lead to the execution of a transaction in a commodity interest and any related cash or forward transactions (but not oral communications that lead solely to the execution of a related cash or forward transaction), whether transmitted by telephone, voicemail, facsimile, instant messaging, chat rooms, electronic mail, mobile device, or other digital or electronic media.[2]

Although broad, as its plain language makes apparent, Rule 1.35 does not require covered market participants to record all communications with clients. First, the rule only applies to communications "concerning quotes, solicitations, bids, offers, instructions, trading, and prices" — that is, communications concerning discrete financial transactions.

Second, only communications that "lead to the execution of a transaction in a commodity interest and any related cash or forward transactions" are covered. Taken together, these two qualifications would seem to exclude all soft information, such as general economic or market trends, interpretations of regulatory developments or requirements, and generic descriptions of the business model or types of services offered by covered market participants.

A reading of Rule 1.35 that excludes such soft information is consistent with the CFTC's public guidance, which provides that "the Commission does not intend for the final rule [1.35] to require the recording of face-to-face conversations that do not occur over electronic, digital or other media."[3]

In other words, because communications "concerning quotes, solicitations, bids, offers, instructions, trading, and prices" typically do not occur in face-to-face meetings, those meetings are not covered by Rule 1.35.

The Obligation to Preserve Client Communications: NFA Rule 2-29

The NFA has its own set of rules governing the content of promotional materials directed to the public, including rules related to the presentation and preservation of electronic communications. NFA Rule 2-29 provides, in part, that no futures commission merchants, introducing brokers, commodity pool operator or commodity trading adviser:

[S]hall use or directly benefit from any promotional material that uses audio or video content to make any specific trading recommendation or refer to or describe the extent of any profit obtained in the past or that can be achieved in the future unless the Member submits the advertisement to NFA's Promotional Material Review Team for its review.[4]

In turn, the definition of "promotional material" provided in Rule 2-29 is, like CFTC Rule 1.35, very broad:

"[P]romotional material" includes ... any text of a standardized oral presentation, or any communication for publication in any newspaper, magazine or similar medium, or for broadcast over television, radio, internet or other electronic medium.[5]

Similarly, NFA interpretative guidance on Rule 2-29 clarifies that the NFA's rules governing electronic promotional materials apply broadly to all internet-based forum and electronic communications:

In many instances, electronic communications may constitute promotional material. Electronic communications directed to the public to solicit business constitutes advertising and is subject to the same rules as any other form of promotional material. For example, an e-mail, text message, or instant message sent to targeted individuals or groups is considered promotional material if the ultimate purpose is to solicit funds or orders.[6]

And like CFTC Rule 1.35, Rule 2-29 requires NFA members to maintain "[c]opies of all promotional material ... for the periods specified in CFTC Regulation 1.31."[7]

 However, also like CFTC Rule 1.35, NFA Rule 2-29 is not without limitations. The most important is the definition of "promotional material" included in Rule 2-29, which limits the term to materials concerning a commodity interest account, agreement or transaction.[8] The phrase "concerning a commodity interest account, agreement or transaction" is further defined to mean:

commodity interest accounts, transactions and orders, commodity pool participations, agreements to direct or guide trading in commodity interest accounts, and agreements and transactions involving the sale, through publications or otherwise, of non-personalized trading advice concerning commodity interests.[9]

Mirroring the CFTC's formula, these definitions appear to limit the NFA's prohibitions on the dissemination and preservation of videoconference presentations to those concerning discrete financial transactions or efforts to solicit specific customer business — and to exclude soft information concerning general economic or market trends and generic descriptions of the business conducted by covered market participants.

Preservation Obligations in the Era of Social Distancing

Before the onset of the COVID-19 pandemic, employees of financial firms met face-to-face with their clients for a host of reasons having nothing to do with the execution of a transaction in financial products or directing or guiding trading in commodity interests — everything from a casual lunch to discuss the state of the markets to detailed presentations made to clients concerning the trade and execution capabilities of proprietary trading platforms.

Some of these meetings may have involved "quotes, solicitations, bids, offers, instructions, trading, and prices" that "lead to the execution of a transaction in a commodity interest," but many more of them did not.

Today, however, nearly all meetings, whatever their purpose, are held through some form of digital or electronic media, thereby potentially bringing them within the letter, if not the spirit, of CFTC Rule 1.35 and NFA Rule 2-29.

The meaning of "face-to-face meeting" has itself become flexible. Meetings held by Zoom, Webex and Skype are now the norm in the financial world, including informal meetings between employees of regulated entities and their clients — even cocktail hours. As a result, there exists the possibility that erstwhile in-person meetings, which the CFTC expressly excluded from the reach of Rule 1.35, may now come within the ambit of regulatory rules requiring the preservation of electronic media.[10]

A particular area of concern is seminars or other group meetings at which financial professionals discuss market trends or other macro information that, by design or not, leads to business for those professionals. For example, Rule 1.35 applies to the transmission of information on such general subjects as trading, prices and instructions.

Would a firm's informational presentation to a group of unaffiliated traders describing how a proprietary trading platform fills customer orders involve instructions about trading or prices? If that presentation resulted in one of the traders sending her options trades to the firm for execution, would that constitute "lead[ing] to the execution of a transaction in a commodity interest"?

Supervisory Procedures Governing Videoconferencing

One way to ensure that these questions are answered correctly is for financial firms to create regulatory compliance procedures that are keyed specifically to videoconference presentations. CFTC and NFA rules require registrants to implement policies and procedures that ensure compliance with the CFTC's and NFA's regulatory framework, including rules related to the dissemination and retention of oral and electronic communications.

NFA Compliance Rule 2-9, for example, "requires [NFA] Members and [Associated Persons] with supervisory duties to diligently supervise employees and agents in the conduct of their commodity interest activities for or on behalf of the Member." Pursuant to this rule, firms' supervisory "procedures must include the supervision of electronic communications used to conduct commodity interest business."[11]

As applied to videoconference presentations in particular, such supervisory procedures should include written guidance to help employees distinguish, for example, between commodity interest activities such as solicitations and trading instructions, and other communications not subject to CFTC and NFA restrictions, such as one-on-one client check-ins concerning social or general economic topics.

In addition, compliance procedures should require compliance personnel to preview the topics to be covered in any firm-sponsored videoconference, and then to spot-check compliance with the firm's procedures by logging into videoconferences on a random and unannounced basis. These activities could be memorialized in a log maintained by the compliance department or other designated responsible person for such purposes.

Conclusion

Given their original purpose, it seems unlikely that the CFTC and NFA will impose an expansive interpretation of Rules 1.35 and 2-29 just because in-person meetings have, for the time being, migrated to videoconference. After all, while the current pandemic has forced a change in the technology we use to communicate, the policy considerations underlying those rules remain the same.

For example, as discussed above, CFTC Rule 1.35's stated intent was to discourage firms from making fraudulent or misleading communications to their customers, and to deter violations, such as trading ahead of customer orders.

As this policy statement suggests, the CFTC was concerned about client communications directly related to the execution of specific financial transactions. Surely there are now more videoconference communications during which bids, offers, and price quotes are transmitted than there were in February. But they still must be a small fraction of the total Zoom, Webex and Skype meetings that have taken place since the country went into quarantine this spring.

As for those other meetings, market participants can feel reasonably confident that the CFTC's and NFA's enforcement arms will not suddenly change tack and begin investigating whether records of videoconferences involving more routine matters are being preserved.

An informational Zoom presentation to a firm's existing clients concerning the impact of COVID-19 on long-term oil price trends seems like safe territory. Webex conferences between colleagues employed by an FCM concerning expected fluctuations in trade volume on the NYMEX also probably will not pique the regulators' curiosity.

And even one-on-one Skype check-ins with firm clients to discuss nontrade-related matters such as the general health of the client's business, prospects for an economic recovery in the fourth quarter, or even whether the client is properly hedged against future market volatility probably do not come within the prohibitions of Rules 1.35 and 2-29.

So, with a few limited exceptions, it may not be necessary to abandon your new videoconferencing habits anytime soon — much as you may want to get back to those in-person lunches.

Correction: A previous version of this article incorrectly stated the authors' titles at the firm. The error has been corrected.



David Slovick is a partner at Barnes & Thornburg LLP. Previously, he was a senior enforcement attorney at the CFTC and the U.S. Securities and Exchange Commission.

Trace Schmeltz is a partner and co-chair of the financial and regulatory litigation group at Barnes & Thornburg.


The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] Adaptation of Regulations To Incorporate Swaps — Records of Transactions, 77 Fed. Reg. 75523, 75528 (Dec. 21, 2012).

[2] 17 C.F.R. § 1.35(a)(1)(iii).

[3] 77 Fed. Reg. at 75530.

[4] NFA Rule 2-29(h).

[5] NFA Rule 2-29(i)(1).

[6]NFA Guide to Communications with the Public and Promotional Material for FCMs, FDMs, IBs, CPOs and CTAs, at 25 (May 2020).

[7] NFA Rule 2-29(f).

[8] NFA Rule 2-29(i)(1).

[9] NFA Rule 2-29(i)(2).

[10] Entities subject to Rule 1.35 were provided limited no-action relief by the CFTC in March of this year, as the COVID-19 pandemic began to interrupt the normal business activities of financial firms. See March 17, 2020 Letter from the CFTC's Division of Swap Dealer and Intermediary Oversight, No-Action Positions for Futures Commission Merchants and Introducing Brokers to Facilitate Physical Separation of Personnel in Response to the COVID-19 Pandemic ("Until June 30, 2020, any requirement to make and keep records of oral communications pursuant to Commission regulation 1.35 if the personnel required to use recorded lines are required by the registrant's written business continuity plan to be absent from their normal business site."). Although the no-action relief was originally set to expire at the end of June, the CFTC recently extended it through September 30, 2020.

[11] NFA Guide to Communications with the Public and Promotional Material for FCMs, FDMs, IBs, CPOs and CTAs, at 41 (May 2020).

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