Board of Trade of City of Chicago v. S.E.C., 81-1660

Citation677 F.2d 1137
Decision Date27 May 1982
Docket NumberNo. 81-1660,81-1660
PartiesFed. Sec. L. Rep. P 98,605 BOARD OF TRADE OF the CITY OF CHICAGO, Petitioner, v. SECURITIES AND EXCHANGE COMMISSION, Respondent, and Chicago Board Options Exchange, Incorporated, Intervenor-Respondent.
CourtUnited States Courts of Appeals. United States Court of Appeals (7th Circuit)

Mahlon M. Frankhauser, Kirkland & Ellis, Washington, D. C., for petitioner.

Paul Gonson, Securities & Exchange Comm., Washington, D. C., for respondent.

Burton R. Rissman, Schiff, Hardin & Waite, Chicago, Ill., for intervenor-respondent.

Before CUMMINGS, Chief Judge, CUDAHY, Circuit Judge, and CAMPBELL, Senior District Judge. *

CUMMINGS, Chief Judge.

The issue in this case is whether the Securities and Exchange Commission (SEC) has authority to regulate trading in options on Government National Mortgage Association mortgage-backed pass-through certificates (GNMA's), given that GNMA's are both "commodities" and "securities." We hold that pending further action by the Commodity Futures Trading Commission (CFTC), all trading of options on GNMA's is prohibited and that the SEC has no jurisdiction of its own to permit trading in GNMA options.

I

Last April the Board of Trade of the City of Chicago (Board of Trade) petitioned us to set aside an order of the SEC approving rule changes of the Chicago Board Options Exchange, Incorporated (CBOE). The CBOE rule changes would have allowed trading on the CBOE of exchange-formed off-set options on GNMA's. The underlying instruments, GNMA's or Ginnie Maes, are the product of a program administered by the Government National Mortgage Association a Government corporation within the Department of Housing and Urban Development. See 12 U.S.C. §§ 1716 et seq.; 24 C.F.R. ch. III. The program is designed to increase liquidity in the secondary mortgage market and attract new private sources of funds into residential loans. Under this program, GNMA certificates are issued by private institutions (primarily mortgage bankers) to represent interests in pools of Government-underwritten residential mortgages. The owner of a GNMA certificate receives a proportion of the income generated as mortgagors in the pool repay their loans, and the timely payment of principal and interest to the GNMA owner is guaranteed by the Government National Mortgage Association. GNMA's, like most securities or commodities, are fully transferable from one investor to another. As the CBOE has advised us, "Institutional investors of all types have been attracted to GNMA's because such investments have favorable yields, good liquidity and a high degree of safety" (Br. 5). Although the regular payments of principal and interest are guaranteed, they are fixed for the life of the pooled mortgages, and consequently GNMA owners bear the risk that mortgage interest rates may fluctuate, making the GNMA certificates more or less valuable. The two derivative instruments at issue here, GNMA options and GNMA futures, allow GNMA traders to transfer the risks associated with value fluctuations to speculators.

The CBOE's proposed market in GNMA options differs from the market in the underlying GNMA's in that when an option contract is traded no GNMA's change hands. The purchaser or "holder" of a GNMA option acquires only the right to buy or sell a specified quantity and quality of GNMA's at a specified price prior to a specified date. Conversely, in return for a premium, the seller or "writer" of the option (here, the CBOE's clearing house) undertakes the obligation of either selling or buying the GNMA's in the event that the holder "exercises" the purchased option. Under the CBOE's proposed rule changes, however, neither party need ever own or deliver any GNMA's in order to profit from the option transaction. The writer of the option may liquidate his position prior to the holder's exercise by purchasing an identical option, in effect transferring the obligation to a new option writer. Likewise, the option holder may recover the value of his option without actually exercising it simply by purchasing an equal but opposite option (an option to buy to match an option to sell, or vice versa). The original option and its opposite, "offsetting" option are then cancelled through the CBOE clearing house. Thus the CBOE's proposed options market could exist and prosper without any of the traders ever exercising the options and buying or selling the GNMA's.

The Board of Trade, a separate market from the CBOE, has since 1975 traded a different GNMA derivative-futures on GNMA's-pursuant to the designation of the other regulatory agency involved in this case, the CFTC. GNMA futures are obligations to make or take delivery of a specified quantity and quality of GNMA's at a particular time in the future and at an agreed price. Both parties to a futures contract are obligated to perform; there is no choice by either party to exercise a right to performance as there is with options. Nevertheless, investors may deal in GNMA futures without ever intending to deliver or take delivery of GNMA's because, like the proposed options, futures contracts may be offset by purchase or sale of an equal and opposite contract. Indeed, futures markets generally are not used to obtain actual delivery of a commodity. Most contracts are fulfilled by entering into an offsetting contract, and fewer than 3% of all futures contracts are fulfilled by taking (or making) actual delivery of the underlying commodity. See Commodity Futures Trading Commission Act of 1974: Hearings on H.R. 11955 Before the House Committee on Agriculture, 93d Cong., 2d Sess. 238 (1974) (statement of Sen. R. Clark); G. Clark, Genealogy and Genetics of "Contract of Sale of a Commodity For Future Delivery" in the Commodity Exchange Act, 27 Emory L.J. 1175, 1176 (1978). The differences between options and futures may be quite technical, see, e.g., Moriarty, Phillips & Tosini, A Comparison of Options and Futures in the Management of Portfolio Risk, Financial Analysts J. 61 (Jan./Feb. 1981), but a complete understanding of the differences has not been necessary to decide this case. 1 Important for understanding the motivation behind this and related lawsuits, however, is the great similarity of functions served by the two GNMA derivatives and the tremendous revenue they may generate for the exchanges on which they are traded. Both options and futures allow GNMA traders to shift to speculators the risk of changing mortgage interest rates, Moriarty, Phillips & Tosini, supra, and the volume of risk-shifting and speculation has been tremendous. In 1981, for example, there were approximately 2,293,000 sales of GNMA futures contracts on the Board of Trade, each contract representing $100,000 in unpaid mortgage principal. Thus when the CBOE proposed rule changes with the SEC to accommodate the creation of a market in exchange-formed off-set options on GNMA's, the Board of Trade filed comments criticizing the CBOE proposal. 2 The Board of Trade argued to the SEC that the proposed options are prohibited under Section 4c(c) of the Commodity Exchange Act, 7 U.S.C. § 6c(c), and that they fall within the CFTC's exclusive jurisdiction over commodity options under Sections 2(a)(1) and 4c(b) of the Act, 7 U.S.C. §§ 2 and 6c(b). 3

The SEC nevertheless approved the proposed rule changes on February 28, 1981, and the Board of Trade filed this petition for review as a person "aggrieved" by the SEC order. Securities Exchange Act of 1934, § 25(a)(1), 15 U.S.C. § 78y(a)(1). 4 The Board of Trade's petition reiterates its objections to the SEC order based on the Commodity Exchange Act and various CFTC regulations. In addition, the petition for review urges that even apart from prohibitions of the Commodity Exchange Act, under Sections 3(a)(12), 9(b), and 9(f) of the Securities Exchange Act of 1934, 15 U.S.C. §§ 78c(a)(12), 78i(b) and 78i(f), the SEC has no authority to regulate options on GNMA certificates. We will consider the Board of Trade's claims based on the Securities Exchange Act of 1934 although arguably they were not raised before the SEC 5 because the SEC has not objected to our consideration of them and because if the claims are correct the SEC has clearly and unambiguously exceeded its statutory jurisdiction. See K.C. Davis, Administrative Law Treatise § 20.00 at 127-128 (Supp.1980) ("No matter how clear the statutory or nonstatutory law may be that exhaustion is required, the reviewing court will not require exhaustion if the agency fails to oppose review on grounds of lack of exhaustion."); First Jersey Securities, Inc. v. Bergen, 605 F.2d 690, 696 (3d Cir. 1979). The Board of Trade's failure to raise these claims is therefore excusable under Section 25(c)(1) of the Securities Exchange Act of 1934, 15 U.S.C. § 78y(c)(1). Cf. Sartain v. Securities and Exchange Commission, 601 F.2d 1366, 1375 (9th Cir. 1979) (denial of due process need not have been raised before SEC). 6

We permitted the CBOE to intervene as a respondent and have had the further benefit of amicus briefs filed by the CFTC, the North American Securities Administrators Association, the Philadelphia Stock Exchange, and the Securities Investor Protection Corporation. After hearing oral argument from both Government agencies and both exchanges on November 4, 1981, we stayed the SEC order pending our resolution of this dispute. 7

II

The CFTC and SEC have taken opposite stands with respect to their jurisdiction to regulate GNMA options. 8 In its order under review, the SEC has taken the position that the Commodity Exchange Act (CEA) is inapplicable to the trading of options on securities on a national securities exchange such as the CBOE and that it has authority under the Securities Exchange Act of 1934 (SEA) to allow such trading. The CFTC, on the other hand, agrees with the Board of Trade that the attempted SEC designation of commodity options...

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