Tuesday, August 01, 2023

Court vacates SEC order treating SPIKES contracts as futures

By Anne Sherry, J.D.

The court of appeals in D.C. has struck down an SEC order directing that contracts based on the SPIKES Index be treated as futures to foster competition with similar futures based on the VIX Index. The order was arbitrary and capricious because the SEC failed adequately to explain its rationale and failed to examine the potential harms to SPIKES futures investors. The court is withholding issuance of its mandate for three months to allow market participants to wind down existing transactions (Cboe Futures Exchange, LLC v. SEC, July 28, 2023, Srinivasan, S.).

Background. In 2020 the SEC issued an exemptive order allowing the Minneapolis Grain Exchange (MGEX) to list futures contracts on the SPIKES Index. By exempting the contracts from the definition of “security future,” the SEC ensured that the SPIKES contracts would be subject only to CFTC regulation. Security futures, on the other hand, are subject to oversight by not just the CFTC but also the SEC, NFA, and FINRA. In addition to this higher regulatory burden, security futures also lack the tax advantages of other futures.

Since 2004, Cboe Futures Exchange (CFE) has listed futures contracts based on the Cboe Volatility Index, or VIX, under a joint SEC-CFTC order exempting these futures from treatment as security futures. The SPIKES and VIX indices both measure volatility of the S&P 500 index, and the SEC reasoned that because VIX futures are regulated as futures, SPIKES futures should be as well, to promote competition. CFE challenged this order by petitioning the D.C. Circuit.

Competition. CFE argued, and the appeals court agreed, that the SEC’s order on SPIKES futures failed to adequately explain why exemptive relief is necessary to enhance competition and provided no basis for assuming that existing products do not already afford sufficient competition.

The appeals court observed that the exemptive order simply identified the goal of promoting competition and then asserted, without elaboration, that SPIKES futures would need to be regulated as futures contracts to achieve this goal. The SEC did not articulate a rational connection between the regulatory treatment of SPIKES futures and the promotion of competition. Relatedly, the order failed to address the possibility that SPIKES futures could provide meaningful competition even if they were treated as security futures.

The exemptive order fails to identify VIX futures by name, referring to it as “the only comparable incumbent volatility product in the market.” It draws this conclusion of uniqueness without explaining what it means for a product to be “comparable” or what characteristics a product must have to compete effectively. It also fails to explain why only volatility futures, and not other volatility products such as security futures, can meaningfully compete—ultimately leaving too many key questions unanswered to satisfy the Administrative Procedure Act.

The court rejected the SEC’s attempt to rely on analyses provided by MGEX. The APA requires “reasoned analysis,” whereas submissions by the regulated entity express the self-serving views of that entity. To rely on MGEX’s analysis, the SEC would have had to critically review and adopt those submissions or perform its own comparable analysis. And while both the SEC and MGEX (as intervenor) argued before the D.C. Circuit that futures enjoy tax advantages over security futures, there was no evidence that the SEC actually relied on this rationale in issuing the exemptive order, which makes no mention of taxation.

Potential harms. Furthermore, the appeals court agreed with CFE that the SEC did not adequately address potential harms to investors. In the exemptive order, the SEC concluded that SPIKES futures meet the statutory definition of security futures before it went on to exempt them from that status. Ordinarily, dealers in security futures would be required to provide investors with a comprehensive disclosure statement. The SEC failed to adequately examine the harms that could befall SPIKES futures investors as a result of eliminating the disclosure requirement.

The SEC was statutorily required to consider the public interest and the protection of investors when issuing the exemptive order. So, while “an agency need not address every conceivable implication of its decision,” a statutorily mandated factor requires consideration.

The Commission countered that the order adequately, but implicitly, addressed the potential harms by establishing exceptions and conditions to the exemptive relief. In the court’s reasoning, the exceptions did nothing to undercut the rationale for providing the disclosure statement to SPIKES futures investors. The exceptions merely preserved the antifraud, antimanipulation, recordkeeping, and inspection requirements that would have been in effect without the exemptive order—but without the exemptive order, investors would have received additional disclosures on top of those investor protections.

Even the SEC’s brief before the appeals court only addressed one risk, and the SEC did not explain how the order’s exceptions and conditions address the risks discussed in the forty pages of the disclosure statement. Disclosures required by CFTC regulations only address some of what is contained in the disclosure statement and are not as thorough. Moreover, the exemptive order never mentions these futures disclosures.

Vacatur. The appeals court accordingly vacated the SEC’s order for being arbitrary and capricious. Vacatur is the usual remedy, and SEC and MGEX did not show that vacatur would be so disruptive a remedy as to justify departing from the normal course. While the agency and exchange raised concerns about allowing investors enough time to unwind transactions, the court addressed this by withholding issuance of its mandate for three months—the time period contemplated in the exemptive order itself.

The case is No. 21-1038.