British American Commodity Options Corp. v. Bagley, s. 863

• Citation: 552 F.2d 482
• Decision Date: 04 April 1977
• Docket Number: 864,865,Nos. 863,D,s. 863
• Court: United States Courts of Appeals. United States Court of Appeals (2nd Circuit)
• Parties: BRITISH AMERICAN COMMODITY OPTIONS CORP. and Lloyd, Carr & Co., Plaintiffs- Appellants-Cross Appellees, v. William T. BAGLEY, Chairman of the Commodity Futures Trading Commission, et al., Defendants-Appellees-Cross Appellants. NATIONAL ASSOCIATION OF COMMODITY OPTIONS DEALERS, a non-profit association, et al., Plaintiffs-Appellants-Cross Appellees, v. The COMMODITY FUTURES TRADING COMMISSION et al., Defendants-Appellees-Cross Appellants. ockets 77-6010, 77-6011 and 77-6019.

Page 482

552 F.2d 482

BRITISH AMERICAN COMMODITY OPTIONS CORP. and Lloyd, Carr &

Co., Plaintiffs- Appellants-Cross Appellees, v. William T. BAGLEY, Chairman of the Commodity Futures Trading

Commission, et al., Defendants-Appellees-Cross Appellants.

NATIONAL ASSOCIATION OF COMMODITY OPTIONS DEALERS, a non-profit association, et al., Plaintiffs-Appellants-Cross Appellees, v. The COMMODITY FUTURES TRADING COMMISSION et al.,

Defendants-Appellees-Cross Appellants.

Nos. 863, 864, 865, Dockets 77-6010, 77-6011 and 77-6019.

United States Court of Appeals Second Circuit.

Argued Feb. 9, 1977.

Decided April 4, 1977.

Charles J. Hecht, New York City (Haig Costikyan and Gusrae, Greene & Kaplan, David Greene, Martin Kaplan, New York City, on the brief), for plaintiffs-appellants-cross appellees British American Commodity Options Corporation and Lloyd, Carr & Co.

Leonard R. Goldstein, College Park, Md., for plaintiffs-appellants-cross appellees National Association of Commodity Options Dealers, Bristol Options, Inc., Chartered Systems Corporation, Cleary Trading Company, Inc., First New York Commodity Options Inc. of Los Angeles, Williston Corporation and International Commodity Options, Ltd.

Frederic T. Spindel, Washington, D. C. (Richard E. Nathan, Acting Gen. Counsel, Commodity Futures Trading Commission, Washington, D. C., and Virginia F. Crisman, Omaha, Neb., on the brief), for defendants-appellees-cross appellants The Commodity Futures Trading Commission, William T. Bagley, John V. Rainbolt, II, Gary Seevers, Read P. Dunn and Robert L. Martin.

Before FEINBERG, GURFEIN and MESKILL, Circuit Judges.

FEINBERG, Circuit Judge:

Nine commodity options dealers and the National Association of Commodity Option Dealers (NASCOD) in this consolidated action challenge new rules that regulate the commodity options industry. The Commodity Futures Trading Commission (Commission) promulgated the rules under authority granted in 1974 by the Commodity Futures Trading Commission Act, Pub.L. 93-463, 88 Stat. 1389, 7 U.S.C. §§ 1-22 (Supp. V, 1975). Plaintiffs claim that the regulatory scheme violates various requirements of the Administrative Procedure Act, 5 U.S.C. §§ 551 et seq. (1970), and the United States Constitution. Prior to the effective dates of the new rules, plaintiffs brought suit in the federal courts ¹ for declaratory relief, and moved for a preliminary injunction against implementation of the rules. With the certified record of the informal rule-making proceeding before him, Judge Whitman Knapp of the United States District Court for the Southern District of New York enjoined the regulation that required segregation of customers' funds, but otherwise denied plaintiffs' motion and granted summary judgment for the Commission. We reverse the injunction against the segregation rule, and in other respects affirm the judgment of the district court.

I The Commodity Options Industry

The commodities business operates as a marketplace of contracts. The contracts traded are for the purchase, or sale, of specific amounts of a commodity ² either that have already been produced, or that will be produced in the future and delivered by a specific date. This latter group of contracts are known as "commodity futures." ³ A "commodity option" is a contractual right to buy, or sell, a commodity or commodity future by some specific date at a specified, fixed price, known as the "striking price." ⁴ A contract entitling its owner to purchase the commodity is known as a "call," and a contract entitling its owner to sell is called a "put." In the plainest case, an option is created, or "written," by the owner of a commodity or commodity futures contract, who commits himself to sell his goods or contract. But an option can also be written by anyone else willing to take the chance that he will be able to cover his obligation in the futures market, if the option purchaser decides to exercise the option. Such an option is described as "naked."

The plaintiff firms in this case deal in "London options," which are options on futures contracts for certain commodities that are traded in London, England, on either the London Metals Exchange (LME) or several other exchanges whose transactions are cleared through the International Commodity Clearing House (ICCH). The plaintiff firms sell London options in the United States and, according to plaintiffs British American Commodity Options Corp. and Lloyd, Carr & Co., operate as follows: Plaintiffs actively solicit customers through direct mail and telephone contacts, as well as by newspaper and television advertising. When a customer orders the purchase of a commodity option, the dealer furnishes him with a notice giving the details of the transaction including the nature of the underlying futures contract, the price the writer charges for the option, known as the "premium," the dealer's commission, and the market on which the trade will be executed. The customer may or may not have paid for the option when this notice is sent; only payment of the purchase price to the dealer commits the customer to buying the option. The price quoted in the notice is firm, however, for five days, which means that the dealer assumes the risk of a price increase during that period. Once the dealer receives cash payment, he executes the trade through a "clearing member" of one of the English exchanges. The dealer then immediately forwards the premium amount to the clearing member, who pays the option writer. At the same time, the dealer sends another notice to the customer giving final details of the transaction. ⁵

To profit from this purchase, the customer must exercise the option before it expires. Exercising the option means buying the underlying futures contract. Since the customer normally has no interest in actually receiving the commodity on the delivery date, the clearing member then sells a futures contract short for the customer. The difference between the price at which the option is exercised plus the cost of purchasing the option (premium and commission) and the price at which the futures contract is sold is the customer's profit. If, however, the market price for the futures contract has dropped below the striking price, the customer allows the option to expire, in which case he loses his entire investment.

Market Regulation

Intimations of difficulties in the commodity options market came to the attention of Congress in the early 1970's; existing laws had not worked well in preventing abuses in the options industry. ⁶ Options were an especially hospitable environment for abuse because a naked option could be created out of nothing, if the writer was willing to run the risk of not covering his obligation by acquiring an offsetting position in the futures market. Thus, entry into the business of options required little capital. In addition, options bear lower price tags than the futures contracts underlying them, so the options market may be peculiarly attractive to individual investors of relatively modest means and with a propensity for taking risks.

Before 1974, regulation of trading in commodity futures and options derived mainly from the Commodity Exchange Act, 7 U.S.C. §§ 1-17b (1970). ⁷ That Act empowered the Commodity Exchange Authority of the Department of Agriculture to administer certain limited regulations on trading in a number of agricultural commodities, ⁸ and completely banned options on them. 7 U.S.C. § 6c (1970). On October 23, 1974, Congress enacted the Commodity Futures Trading Commission Act, supra, which created the Commission as an independent regulatory agency with plenary rulemaking power. The Act also substantially broadened the field of regulation, to include virtually all "goods and articles," see note 2, supra. ⁹ The Commission was given

exclusive jurisdiction with respect to accounts, agreements (including any transaction which is of the character of, or is commonly known to the trade as, an "option", "privilege", "indemnity", "bid", "offer", "put", "call", "advance guaranty", or "decline guaranty"), and transactions involving contracts of sale of a commodity for future delivery.

7 U.S.C. § 2 (Supp. V, 1975).

The new Act perpetuated the old Act's absolute ban on option trading for the commodities listed in the old Act, 7 U.S.C. § 6c(a) (Supp. V, 1975), but permitted other options to be written and to trade in compliance with rules promulgated by the Commission. 7 U.S.C. § 6c(b) (Supp. V, 1975). The Act authorized the Commission "to make and promulgate such rules and regulations as, in the judgment of the Commission, are reasonably necessary to effectuate any of the provisions or to accomplish any of the purposes of this chapter." 7 U.S.C. § 12a(5) (Supp. V, 1975).

On April 25, 1975, soon after the Commission came into official existence, it published for public comment a proposed anti-fraud rule, 40 Fed.Reg. 18187 (1975), that broadly proscribed fraudulent and deceptive practices and the making of false statements in connection with commodity options transactions. The anti-fraud rule became effective June 24, 1975. The Commission explained that its swift action was necessary because the Act's grant of exclusive jurisdiction to the Commission had left the public without regulatory protection.

In October 1975, the Commission announced that it was considering rules to regulate or prohibit all options trading. The Commission also announced the appointment of an Advisory Committee on the Definition and Regulation of Market Instruments ¹⁰ to study the options situation and recommend suitable regulations. The public notice solicited suggestions of temporary rules to be adopted, and offered for consideration a number of alternative approaches: prohibition of all commodity options transactions; restricting options trading to established contract markets; allowing trading only of options written as part of a Commission-approved "business plan"; prohibition of "naked" options;...