The Securities and Exchange Commission has cautioned exchanges and investment professionals to monitor the composition of indices used in offering financial instruments to determine if they are security futures products and ensure they are complying with the federal securities laws.
The SEC’s report of investigation stems from an inquiry into a foreign derivatives exchange that was offering and selling futures to US customers on what was initially a broad-based index not subject to the registration requirements of the federal securities laws. The index later transitioned to a narrow-based security index, leaving it without a valid exemption from the securities laws.
The SEC’s report reminds exchanges and investment professionals to establish policies and procedures to consistently monitor the composition of indices on which futures are based to establish whether or not they are offering security futures products.
“As the compositions of exchange indices fluctuate, it is critically important for exchanges to have policies and procedures in place to effectively monitor the composition of their indices and ensure that they are appropriately offering securities based on those indices to US investors,” says Daniel M Hawke, chief of the SEC enforcement division’s market abuse unit. “It is equally important for investment professionals to be mindful of the highly analogous situation involving security-based swaps, and the failure to appropriately monitor the characteristics of such financial instruments risks violating the federal securities laws.”
The SEC’s investigation into Eurex Deutschland revealed that the exchange began offering and selling futures on its Euro Stoxx Banks Index to US customers more than 10 years ago pursuant to a Commodity Futures Trading Commission (CFTC) no-action letter obtained in part through Eurex’s representation that it was a broad-based index subject to the CFTC’s exclusive jurisdiction. In October 2011, Eurex reviewed the index for the first time in response to a request by the CFTC to confirm it was still broad-based. During the review, Eurex discovered and self-reported to the SEC and CFTC that the index had transitioned in April 2010 from a broad-based to a narrow-based security index as defined by Section 3(a)(55)(B) of the Securites Exchange Act of 1934. From April 2010 to October 2011, Eurex sold six million contracts on the index through approximately 79 foreign-based broker-dealers, some of which offered direct market access to the index through trading terminals in the US. Other orders were facilitated through omnibus customer accounts carried by foreign-based intermediaries on behalf US investors.
According to the SEC’s report, Eurex did not comply with Section 6(h)(1) of the Exchange Act by effecting transactions in security futures that were not listed on a national securities exchange or national securities association for US investors. Eurex also failed to comply with Section 5 of the Exchange Act by not registering as a national securities exchange, and by offering and selling security futures in the US without registering the transactions or having a valid exemption from registration. The Commission has decided to issue this report and forego an enforcement action against Eurex in part because of its substantial and timely cooperation with the investigation and its prompt remediation efforts. After self-reporting the findings of its review, Eurex extensively cooperated with the SEC staff and voluntarily provided updates and documents. Eurex has since implemented comprehensive policies and procedures that now require monthly, and in some instances daily, compliance monitoring of indices on which it offers futures contracts in the US.
The SEC’s report notes that in analogous situations involving security-based swaps, investment professionals who engage in swap transactions are responsible for ascertaining the swap’s characteristics. When the swaps are securities-based, they must ensure that they are following the registration requirements of the federal securities laws and appropriately offering these financial instruments to US investors.