Bd. Trade City of Chicago v. Secur & Exch Comm'n

• Decision Date: 07 October 1999
• Docket Number: No. 98-2923,98-2923
• Citation: 187 F.3d 713
• Parties: (7th Cir. 1999) Board of Trade of the City of Chicago, Petitioner, v. Securities and Exchange Commission, Respondent
• Court: U.S. Court of Appeals — Seventh Circuit

Page 713

187 F.3d 713 (7th Cir. 1999)

Board of Trade of the City of Chicago, Petitioner, v. Securities and Exchange Commission, Respondent.

No. 98-2923

United States Court of Appeals, Seventh Circuit

Argued February 17, 1999

Decided August 10, 1999

Rehearing Denied October 7, 1999

Petition for Review of an Order of the Securities and Exchange Commission

[Copyrighted Material Omitted] Before Cudahy, Coffey, and Easterbrook, Circuit Judges.

Easterbrook, Circuit Judge.

Although the Dow Jones Industrial Average may be the world's most famous stock market index, the Dow Jones Transportation Average is its most venerable, having been established in 1884. The Dow Jones Utilities Average, which dates from 1929, is another well known indicator. An index uses a few stocks to approximate the performance of a market segment. For example, the 20 stocks in the transportation index are designed to track a portfolio of approximately 145 transportation stocks with a capitalization exceeding $200 billion. The 15 stocks in the utilities index stand in for a utilities segment of 145 firms with a capitalization near $300 billion. When Charles Dow designed these indexes, long before instantaneous worldwide networks, a "computer" was a person who calculated tables of artillery trajectories in longhand on foolscap. In that era a reference to a few stocks as an approximation of many was a valuable time-saving device. Today it is easy to follow the average value-weighted price of a whole market, which an electronic computer can produce at the touch of a button. Each investor can specify and follow the portfolio that seems most interesting or important. Still, indexes have retained their fascination with the media and the public, and they have developed a new use--as the base of futures contracts. Our case presents the question whether futures exchanges may trade contracts based on the Dow Jones Utilities Average and the Dow Jones Transportation Average. For many years Dow Jones was unwilling to license its indexes (rather, the trademarks used to denote them) for use in futures contracts. In 1997 it changed its mind and set in train these proceedings.

"A futures contract, roughly speaking, is a fungible promise to buy or sell a particular commodity at a fixed date in the future. Futures contracts are fungible because they have standard terms and each side's obligations are guaranteed by a clearing house. Contracts are entered into without prepayment, although the markets and clearing house will set margin to protect their own interests. Trading occurs in 'the contract', not in the commodity." Chicago Mercantile Exchange v. SEC, 883 F.2d 537, 542 (7th Cir. 1989). See also Dunn v. CFTC, 519 U.S. 465 (1997). The classic futures contract involves a commodity such as wheat, but in principle any measure of value can be used. Financial futures usually take the form of a contract that depends on the value of an index at some future date. Thus, for example, the buyer (the "long") of a futures contract based on the Standard & Poor's 500 Index future might promise to pay 100 times the value of that index on a defined future date, and the seller (the "short") will receive that price. Either side may close the position by buying or selling an offsetting obligation before the expiration date of the contract.

Financial futures contracts are useful for hedging or portfolio adjustment. They facilitate risk management-- that is, assignment of the inevitable risks of markets to those best able to bear them. See generally Merton H. Miller, Merton Miller on Derivatives 79-100 (1997); Robert C. Merton, Applications of Option-Pricing Theory: Twenty-Five Years Later, 88 Am. Econ. Rev. 323 (1998); Myron S. Scholes, Global Financial Markets, Derivative Securities, and Systemic Risks, 12 J. Risk &amp Uncertainty 271 (1996). Someone who owns a mutual fund containing all of the Standard & Poor's 500 stocks can cut risk in half by selling a futures contract based on the S&P 500 index, or double the market return (and the risk of loss) for the same financial outlay by buying a S&P 500 futures contract. A futures contract based on a market segment (such as utilities) also may be used for portfolio adjustment. Suppose the investor wants to hold a diversified portfolio of stocks that does not include utilities. This investor might own a broadly representative mutual fund and then sell a futures contract based on a utilities index. Similarly, a person who wants to obtain the returns (and take the risks) of particular market segments that do not have their own mutual fund-- for example, a combination of utilities and transportation stocks, but no industrials-- could purchase an appropriate combination of futures contracts. Using these contracts for portfolio adjustment is attractive because the transactions costs of trading futures are much smaller (by an order of magnitude) than the costs of trading the underlying stocks in equivalent volumes. A pension fund that wants to move from stocks to the equivalent of a mixed stock-and-bond portfolio, without incurring the costs of trading the stocks, can do so by selling a futures contract on an index. See Merton Miller on Derivatives at 86-89.

For many years the traditional futures markets, such as the Chicago Board of Trade, have been at odds with the traditional stock markets, such as the New York Stock Exchange, about where financial futures would be traded--and whether they would be traded at all. The stock exchanges prefer less competition; but, if competition breaks out, they prefer to trade the instruments themselves. The disagreement has spilled over to the regulatory bodies. The Securities and Exchange Commission, which regulates stock markets, has sided with its clients; the Commodities Futures Trading Commission, which regulates boards of trade, has done the same. In 1982 this court held that institutions within the CFTC's domain are authorized to trade financial futures (including options on these futures), and, because of an exclusivity clause in the Commodity Exchange Act, that the stock markets are not. See 7 U.S.C. sec.2; Chicago Board of Trade v. SEC, 677 F.2d 1137 (7th Cir.), vacated as moot, 459 U.S. 1026 (1982). Because the stock exchanges long had traded options, a financial derivative related to futures, a political donnybrook accompanied the regulatory dispute among the markets and agencies. Shortly after our opinion issued, Congress amended the Commodity Exchange Act to reflect a compromise among the CFTC, the SEC, and the exchanges.

Congress allocated securities and options on securities to exchanges regulated by the SEC, futures and options on futures to boards of trade regulated by the CFTC. If an instrument is both a security and a futures contract, then it falls within the CFTC's domain. (This is the basis of Chicago Mercantile Exchange, which held that a novel "index participation" is a futures contract that belongs to boards of trade.) Options on single securities are allowed, but futures contracts on single securities are not. This allocation appears to be a political compromise; no one has suggested an economic rationale for the distinction. Having drawn this line, however, Congress had to make it stick. Futures contracts thus must reflect "all publicly traded equity or debt securities or a substantial segment thereof". 7 U.S.C. sec.2a(ii)(III). Finally, both agencies participate in the process of reviewing applications to trade new financial futures contracts. Before a new contract may start trading, both the SEC and the CFTC must certify that it meets the statutory criteria. Regulation of the trading process belongs exclusively to the CFTC.

A year after this statute was enacted, the SEC and the CFTC issued a Joint Policy Statement spelling out the kinds of financial futures that the agencies believed suitable for trading. 49 Fed. Reg. 2884 (Jan. 24, 1984). The Joint Policy Statement is not a regulation and lacks legal force, but for many years the markets observed its limits when proposing new contracts. One element of the Joint Policy Statement is that any index used as the basis of a futures contract contain at least 25 domestic equity issuers. The Dow Jones Transportation Average is based on 20 stocks, the Utilities Average on 15. The second element is that, in a price-weighted index, no single security may have a weight exceeding 10% of the entire index, if its price weighting exceeds its capitalization weighting by a factor of three. In April 1997 Dow Jones replaced one firm in its Utilities Average with Columbia Gas, which accounts for 2.93% of the Utilities Average by capitalization weight, but 12.56% by price weight. The Transportation Average does not contain a stock with a similar disparity.

A brief detour into price-weighting may be helpful. All Dow Jones averages are price weighted, the only practical way to construct an index before electronic calculation. Price weighting means that the prices of all stocks in an index are added together, then divided by a number that the maintainer of the index selects to preserve consistency over time as stocks are split, firms enter or leave the index, and so on. If one stock in a price-weighted index undergoes a rapid rise in price, that stock can come to have an influence disproportionate to its capitalization. (Think of a stock of a small company that doubles in price. This will drive up the value of the index more than a 15% increase in the price of a much larger company, even though the bigger company's increase yields a larger improvement in investors' wealth.) Indexes constructed since the advent of electronic computers are value-weighted (that is, each stock affects the level of the index according to the ratio of its total market capitalization to that of all other securities in the index), and value- weighting in principle leads an index to be a more accurate reflection of the portfolio. See James H. Lorie & Mary T....