Introduction

"Derivatives." That's the 11-letter, four-letter word.

Richard Syron, Chairman
American Stock Exchange
Fortune Magazine (March 2002)

Late one cold January afternoon, Joanne, a private individual investor, called to ask for help.[1] Joanne was very hesitant to talk about her issue, but it was clear from her shaky voice that she needed to share what had happened to her and ask for advice. Over the course of approximately two hours, the following story unfolded.

Joanne was a victim of fraud. B&B Investments[2] contacted Joanne through Stephanie,[3] a broker working for the company. Stephanie told Joanne that she obtained Joanne's name through an investment questionnaire that Joanne completed on-line. Stephanie offered Joanne investment opportunities in the foreign currency market ("Forex").[4] Stephanie described herself as "an expert in the Forex market" with "ten years of Forex trading experience" and "Stephanie knew when to pull investors in and out of the market." Stephanie proposed an investment plan to Joanne, which would involve "leveraging 100,000 American Dollars to purchase British Pounds," which was "a good buy." Joanne told Stephanie that she could not afford to invest $100,000 because she was a culinary student with an annual income of $20,000. In that case, Stephanie told Joanne that she could invest in "British Pound options which would only require a small capital investment," rather than $100,000 to purchase the actual currency. Stephanie told Joanne that she could send a check for $3,000 to B&B Investments. Joanne agreed to send the money.

Joanne received a federal express package from B&B Investments with a contract that Stephanie told her was "already completed for her convenience," and a post-it note instructing her to "sign here." Joanne tried to read the contract but did not understand it. Stephanie told Joanne not to worry about the contract, it was "all boiler plate legal stuff," and the contract simply re-stated the information that Stephanie verbally shared with Joanne. Joanne signed the contract and sent a check for $3,000 to B&B Investments.

Stephanie called the following day to tell Joanne that she received the check, and Joanne should start watching the financial news to track the progress of her investments. Joanne watched the financial news diligently over the next few weeks. To Joanne's dismay, a few weeks later the British Pound began to decrease in value. Joanne called Stephanie to place a stop-loss order. [5] Stephanie refused to place a stop-loss order on Joanne's trade and told Joanne "B&B Investments does not believe in stop-loss orders." By the end of the month, Joanne's option on the British Pound was worthless. Her $3,000 investment was worth nothing. Joanne was ashamed and embarrassed. Nonetheless, she contacted a number of attorneys in New York and Florida, but they all told Joanne that she "didn't lose enough money."

A friend recommended that Joanne contact the National Futures Association ("NFA").[6] The NFA told her that the commodities[7] market was within the jurisdiction of the Commodities Futures Trading Commission ("CFTC" or "Commission").[8] Joanne had never heard of the CFTC, but she contacted the CFTC and spoke with a member of the New York Enforcement Division, who took a brief statement from Joanne and said they would look into the matter. Several weeks passed and Joanne heard nothing from the CFTC. Joanne's friend recommended that she contact a law school-based Securities Arbitration Clinic, and Joanne found me.

[9]

Most investors are unfamiliar with the futures market and the CFTC, in part, because individual investors receive news reports or marketing materials about securities or equities markets and not futures markets. Beginning in the early 1990s, discount brokers and self-directed on-line securities trading brokerage firms such as Schwab, Ameritrade and E*trade became common. Small investors began to enter their own trades, often with limited understanding of the stock and financial markets, which nonetheless resulted in fabulous returns. At the zenith of the market in 2000, stocks such as Infospace Inc. traded at $1,400 per share[10] and small investors with self-directed on-line trading accounts were offering stock tips to their friends and neighbors. In contrast, the futures market never received the combustible trading synergy that occurred in late 1990s and early 2000 with equities. One reason is because of the perception that the futures market is esoteric: it falls within the inner sanctum of more sophisticated investors such as banks, institutional and highly experienced private investors. As a result, Forex investment fraud is a relatively new investment fraud that appears to have been gaining momentum since the mid-1990s.

A.

[11] such as B&B Investments. These disputes arise in the definition of the terms: (1) "transactions in foreign currency," (2) "board of trade," and (3) "futures contract." As Congress, the Treasury Department, and the courts struggle to resolve these jurisdictional disputes, Forex fraud will continue to increase exponentially. Consequently, unsuspecting small investors such as Joanne will remain vulnerable to the high-pressure manipulative sales techniques of unscrupulous brokers.

This article generally explores the loopholes in market regulation. Part I outlines corporate scandals that have shadowed Forex problems and provides a review of the financial instruments at issue-Forex derivatives. Part II outlines the legislative history of the Commodity Exchange Act ("CEA"), the Treasury Amendment, and reviews the limits of Securities and Exchange Commission authority to regulate only financial instruments that are securities.[12] Part III more closely reviews the inter-play between the Forex market and regulations including the SEC and CFTC enforcement actions against boiler rooms, in particular, the difficulty with reaching uniformity in the definitions of the terms: (1) "transactions in foreign currency," (2) "board of trade," and (3) "futures contract. Part IV reviews the problem with arriving at a consistent judicial interpretation of Forex, based on opinions from the Supreme Court as well as the Second, Fourth, Ninth, and Seventh Circuits.

Part V analyzes Congressional modifications to the Treasury Amendment, its repeal, and the creation of the CFMA.[13] The CFMA provides the CFTC and SEC with dual enforcement authority to commence enforcement actions. Notably, Part V reviews the Seventh Circuit's wisdom in rejecting the CFTC's enforcement authority in CFTC v. Zelener.[14]

Finally, this article proposes several amendments to the CFMA: (1) re-defining the term "board of trade" to make it applicable to Forex entities to the extent that the Forex entities are not already subject to other federal regulation, (2) requiring registration of all Forex entities with the CFTC, (3) setting forth liability for such failure to register as an automatic submission to the jurisdiction of the CFTC, (4) setting forth a practical totality of the circumstances analysis similar to the Second Circuit's analysis in CFTC v. Int'l Financial Services, (5) issuing permanent injunctions against the principals of Forex boiler rooms that defraud the general public, and (6) imposing criminal sanctions against any Forex boiler room and its principals by referring such cases to the U.S. Attorneys' Office or state securities regulators for prosecution. Part VI concludes with an argument for greater federal control within a flexible regulatory framework that will not hinder existing forward and futures transactions in the Forex market, but will allow the CFTC and SEC to take swift and decisive action against Forex entities that defraud the public.

[15] Americans barely caught their breath when, in November of 2001, the Arthur Andersen scandal broke after allegations that Arthur Andersen shredded documents related to Enron's audit. Americans were still reeling from the Arthur Andersen scandal when, in January of 2002, the Kmart scandal broke after allegations that an anonymous letter from Kmart employees claimed that Kmart's accounting practices mislead investors about the company's financial health.

The WorldCom scandal followed the Kmart and Global Crossing scandals. In March 2002, the WorldCom scandal included allegations that WorldCom overstated cash flow by booking $3.8 billion in operating losses as capital expenses. There were also allegations that WorldCom also gave its president, Bernie Ebbers, $400 million in off-balance sheet personal loans.

The Adelphia Communications scandal broke in April of 2002, as well. In this scandal, allegations involved the Rigas family, founders of the company, collecting $3.1 billion in off-balance sheet personal loans secured by Adelphia's assets, overstating results by inflating capital expenses and hiding billions in debt.[16] Because of the numerous scandals in the corporate sector, it is no wonder that the financial media failed to report on commodities market scandals with similar zeal.

The SEC was the investigating agency in each corporate scandal. The SEC often conducted investigations in conjunction with the Department of Justice. Notwithstanding, the SEC sometimes conducted investigations in conjunction with the U.S. Attorneys' Office, State Attorney Generals' Offices, or the CFTC. However, the CFTC's involvement in investigating corporate scandals is limited to allegations of futures[17] or options[18] trading. For instance, the CFTC worked in conjunction with the SEC to investigate the CMS Energy, Dynegy, and Reliant Energy scandals in May of 2002. The allegations were that CMS Energy, Dynegy and Reliant Energy executed "round-trip"[19] trades to artificially boost energy trading volumes. The trades included both securities and futures, which triggered the CFTC's jurisdiction.

[20] Futures and forwards contracts are derivate instruments and integral components of the Forex transactions that derive their value from foreign currency exchange rates.[21] Foreign exchange rates are "what it costs to exchange one country's currency for another country's currency."[22] Forex transactions are also the largest segment of the derivatives market, with daily average trading turnover of approximately $1.5 trillion.[23]

A derivative is a financial instrument that derives its value from an underlying asset, index, or rate.[24] There are numerous examples of derivatives in the financial markets. Investors can trade derivatives on organized exchanges,[25] such as the Chicago Board of Trade, or over the counter ("OTC"). Essentially, a financial instrument is designated as a derivative based upon location of trading and regulation agency.[26]

Futures,[27] options,[28] and forwards[29] are financial instruments that entities such as producers, manufacturers, wholesalers, retailers and investors trade to reduce risks associated with buying or selling commodities.[30] These traders reduce their exposure to price fluctuation by "hedging."[31] Hedging is the purchase of a future or option in the underlying commodity.[32] The most fundamental hedging devices are the forward and futures contracts. These contracts guarantee the future delivery of a commodity for a present-agreed upon price. For the purchaser of the commodity, it eliminates the risk of increasing or decreasing prices. The purchaser of the commodity enters into a forward or futures contract with a third party investor outside of the original commodity purchaser-seller agreement. The purpose of the separate forward or futures contract is to shift the risk of price fluctuations from the original commodity purchaser to another investor.[33]

Futures and forward contracts are fundamentally different, but virtually indistinguishable on paper. However, there is one distinguishing characteristic: the parties to a forward contract expect actual delivery of the commodity. In a forward transaction, the purchaser needs the delivery to occur at some date in the future. In contrast, the parties to a futures transaction do not expect actual delivery of the commodity to occur[34] because a futures contract is a pricing technique for parties' hedging their investment risk.[35] Futures contracts are a financing technique that is a "pure hedge play" used to offset risk in an investment transaction.

A hypothetical real estate transaction can illustrate the mechanics of a futures contract. For example, a homebuyer enters into a purchase and sales agreement to purchase a house for $400,000. The closing (delivery of the house) will take place in 90 days, and the homebuyer pledges a deposit of 20% ($80,000). A few days later, the homebuyer becomes concerned that the real estate market will plummet, decreasing the value of the property by 40% ($160,000). The homebuyer could cancel the purchase and sales agreement, but they would lose the $80,000 deposit (and be wrong about their prediction). Alternatively, the homebuyer could hedge their risk that the value of the house decreases by finding an investor (a speculator) that is willing to enter into a separate agreement (futures contract) with the homebuyer, based upon the value of the property at closing. The homebuyer pays the investor $20,000 upfront for agreeing to take on the risk that the property value will increase, counter to the homebuyer's position that the value will decrease. At closing, if the value of the house decreases to $160,000 as the homebuyer predicted, the investor pays $160,000, thereby making the homebuyer whole. If, however, the value of the house increases as the investor predicted, the homebuyer pays the investor the increased amount, which could be anywhere from $1 to more than $160,000. Here, the investor makes money at the front-end on the contract fee ($20,000) and has the potential to make a great deal more money on the back-end (varying between $1 to $160,000 or more). The homebuyer, furthermore, is effectively protected against price fluctuation: their potential loss of $160,000 for a nominal contract fee of $20,000.

Because of its very fluid nature, Forex trades have the potential to result in very large losses for investors. Forex market speculators are willing to take the counter position in currency trades. When they are right about their predictions, they make a lot of money. The inverse is also true; when they are wrong, it may not cost them much "out of pocket," but it can nevertheless result in a very large loss. The result is that the outcome depends on the value of the underlying asset in the market. Investors are willing to enter into futures contracts because it allows them to shift their risk of price fluctuation to another investor. In our example, if the prediction was correct and the property decreased by $160,000, the investor must pay the homebuyer $160,000. Consequently, the homebuyer's net loss is $20,000, the price of entering into the futures contract. This reduction of risk is the advantage of derivative contracts. Derivative contracts are attractive financial instruments, because they (1) standardize the terms of the futures contract (save the price term), (2) confer the right of free transferability of the contract, (3) fix the market location on an organized exchange or with a registered association, and (4) provide price certainty of commodities days, weeks, or months into the future.[36] For an investor to shift the risk, the investor must enter into a forward or futures contract with a counter-party who contractually assumes (swaps) the risk of the counter position[37] which the hedger[38] has foregone. This counter-party is a speculator who assumes that future price fluctuations will move opposite of what the hedger predicts.[39] Therefore, the counter-party purchases a position inapposite to the hedger.[40] As compensation for assuming this risk, the speculator reaps higher profits, assuming that his wager against the hedger is accurate. This interplay between hedger and speculator benefits the commodity market because it aids the pricing mechanism in determining the fair market value and reduces the costs of commodity contracting by standardizing the process.[41] This interaction increases liquidity and efficiency in the commodity markets.[42]

Many individuals believe that derivatives are extremely risky investments, especially given the highly publicized massive derivative losses arising from situations such as Orange County, California's bankruptcy[43] and Long-Term Capital Management's federal bailout.[44] Ironically, derivatives, when properly employed, do not present any greater risk than other financial instruments.[45] Risk depends on the controls that management implements to control the risk inherently associated with derivatives. However, management of derivatives is more complex, and mismanagement has resulted in significant financial losses, further resulting in the need for greater federal regulatory control. There are primarily four types of risks associated with derivatives: (1) market risk, (2) credit risk, (3) operational risk, and (4) legal risk.[46]

Institutional investors, such as banks, maintain written policies and procedures that identify the risk tolerance of the board of directors. The board of directors establishes the risk tolerance of the institutional entity engaging in derivatives transactions. Institutional policies also delineate the lines of authority and responsibility for managing the derivatives activities.[47] In contrast, Forex boiler rooms do not maintain any such policies and procedures. Furthermore, unsophisticated small investors involved in derivatives transactions with Forex boiler rooms are not fully aware of all policies and procedures that relate to their trading liability.[48] Even assuming that Forex boiler rooms maintained such policies and procedures, an unsophisticated small investor would likely have difficulty comprehending the ramification of such policies and procedures on their trading activity.

This is precisely why the policy underlying the CFTC's enforcement authority is an offensive measure designed to prevent Forex boiler rooms from entering into transactions with inexperienced counter-parties. As such, Forex boiler rooms may not enter into derivatives transactions with small investors. More importantly, Forex boiler rooms that engage in fraudulent activity should automatically be subject to CFTC's jurisdiction, and to the extent possible, the SEC's jurisdiction.

[49]

Every day unscrupulous brokers defraud hundreds of unsophisticated small investors.[50] Yet the public is relatively unaware of Forex investment fraud. This is, in part, due to the media's focus on corporate scandals since the Enron debacle in October 2001.[51]

[52] In 1922, the Supreme Court in Hill v. Wallace[53] held that the Futures Trading Act was unconstitutional because it overreached Congress' taxing power. Undaunted, Congress immediately passed the Grain Futures Act,[54] based upon its power under the Commerce Clause.[55] The new act was identical to the Futures Trading Act and the Supreme Court upheld its constitutionality.[56]

In 1936, Congress revised the Grain Futures Act and renamed it the Commodity Exchange Act. The Commodity Exchange Act was promulgated to stem the tide of "boiler rooms or bucket shops" and commodity trading abuses.[57] Congress wanted to prevent unregistered trading establishments from using high-pressure manipulative sales tactics to convince small investors to speculate on securities or Forex markets without reporting the transactions to a board of trade or organized exchange.[58]

A boiler room's primary purpose is to defraud the public. "Traders" within a boiler room are sales personnel with very little training and typically no securities license. The risk of net positions is borne by the boiler rooms and offset by bets against the boiler room's funds.[59] In essence, the small investor is trading against the boiler room as an undisclosed counter-party to the transaction. It is a very secretive, insular transaction, which usually results in the small investor losing everything. In the rare occasion that an investor's position makes a substantial profit, the boiler room simply leaves town and re-establishes itself under a different corporate name,[60] leaving the unsophisticated small investors unable to collect.[61]

Boiler rooms proliferated in the early part of the twentieth century. Several states adopted securities laws commonly referred to as blue sky laws[62] in an effort to control boiler room activities. Nowhere is the court's abhorrence to boiler room activities more eloquently stated than in the decision of Western Union Telephone v. State:

[T]he mischief and evil consequences resulting to the state from the operations of the bucket-shop are almost beyond computation. It assumes an air of legality and respectability, and insidiously ensnares many innocent victims before the public learn of their danger. Its nefarious practices are directly responsible for innumerable bankruptcies, defalcations, embezzlements, larcenies, forgeries and suicides. It ought to be outlawed by statute, as its existence is a menace to society, and its operations immoral, contrary to public policy and illegal.[63]

Boiler room activities were so repugnant that the government responded with the Commodity Exchange Act ("CEA"), restricting futures trading to government approved contract makers[64] such as banks and other institutional investors. The CEA also banned all Forex trading not conducted on an authorized "board of trade."[65] Congress intended, although not specifically stated in the CEA, to prohibit boiler rooms from trading with small investors in order to protect the general public from fraud.

Until 1970, the Department of Agriculture administered the CEA to monitor contract markets and foster self-regulation.[66] In the 1960s, various problems began to occur primarily because of the development of the futures industry. For example, sugar fell outside the scope of the CEA and became a self-regulated industry.[67] The contract market began to fail, and futures were becoming increasingly critical to the proper pricing of the underlying commodity.[68]

In 1974, Congress comprehensively revised the CEA with the passage of the Commodity Futures Trading Commission Act ("CFTCA"),[69] which established the CFTC as an independent regulatory agency charged with the supervision of the contract market. Although Congress gave the CFTC exclusive jurisdiction over commodity futures and options, the CFTCA did not specifically exclude the regulation of swaps,[70] forwards,[71] or hybrids[72] from CFTC jurisdiction. The Treasury Amendment was adopted to specifically address this ambiguity in the CFTCA.[73] In addition, the definition of "commodity" was expanded to include nearly all agricultural products and "all other goods and articles . . . services, rights and interests."[74] This definition included a broad range of financial instruments not previously subject to CEA jurisdiction, including Forex transactions.

Since its creation in 1974, the CFTC has had challenges maintaining its authority, especially with older and more powerful federal financial regulators such as the SEC and the Federal Reserve. In 1998, Congress intervened, placing a moratorium starting in 1999 on CFTC rulemaking,[75] interpretative releases, and policy statements for swaps and hybrid instruments.[76] The bill raised political accountability concerns, in particular, preventing the CFTC from interfering with the OTC swaps markets.[77] The bill provided that "notwithstanding the [moratorium], the Commission may . . . take such actions as the Commission considers appropriate to respond to a market emergency.[78] This type of strained relationship between the CFTC and more established federal regulators has often resulted in concerns regarding the extent of the CFTC's authority. Nowhere is that more evident than in the creation of the Treasury Amendment.

[79] This exemption is popularly known as the Treasury Amendment. Originally, the Treasury Department opposed the potential scope and lack of clarity of the CFTC because it feared an overlap between the banking and commodity regulations.[80] The Treasury Department wrote a letter to the Senate Banking Committee to express its concern and recommended alternatives.[81] The Treasury Letter addressed trading in foreign currency by banks and institutions, and stated that this particular market was already subject to banking regulations that did not require any additional federal regulations.[82] Congress agreed and adopted the Treasury Amendment, taking language almost verbatim from the Treasury Letter.

The adoption of the Treasury Amendment limited CFTC jurisdiction and excluded certain financial instruments from CFTC enforcement authority. As such, the CFTC had no jurisdiction over: (1) Forex transactions between "eligible contract participants,"[83] (2) futures commission merchants ("FCM"),[84] (3) broker dealers already subject to federal regulation by the SEC, and (4) sophisticated professional investors who have personal assets exceeding certain statutory amounts.[85] In 1982, the CFTC underwent Congressional action to resolve a jurisdictional conflict with the SEC.[86] The CFTC's authority was expanded to include futures, options, and swaps transactions that trade on organized exchanges.[87] As a result, the CFTC currently has jurisdiction over all futures and options sold or purchased on a "board of trade" or organized exchange.[88]

This patchwork of regulation has created confusion as to who may or may not legitimately participate in Forex transactions. Small investors may participate in Forex transactions only when the investors' counter-party for a Forex transaction is a member of a group of regulated entities, such as banks, broker dealers, or FCMs. Currently, a Forex counter-party cannot be a Forex boiler room because a Forex boiler room trades off-exchange and such trades and entities were not contemplated by the Treasury Amendment. Forex trading and options transactions between Forex boiler rooms and unsophisticated small investors are illegal.[89] However, despite this prohibition regarding the illegality of Forex boiler room trades, the CFTC faces a great amount of difficulty in commencing enforcement actions against Forex boiler rooms that have engaged in illegal trades. The CFTC has the burden of proof and must prove that the transaction is illegal and within the jurisdiction of the CFTC.

[90] (3) the contract was a futures contract, and (4) the public was defrauded. [91]

It is unclear whether the CFTC must prove all of the following factors. The Forex transaction in question must be a futures contract because the Treasury Amendment and the CFMA exclude forward contracts from CFTC jurisdiction. In addition, the CFTC must make an initial showing that the Forex boiler room is not a member of a group of regulated entities.

To prove fraud, the CFTC can: (1) produce the misleading brochures distributed to small investor, (2) produce the affidavits of small investors alleging that manipulative and deceptive sales techniques were utilized by unregistered and unlicensed brokers, (3) show the Forex boiler room's failure to enter trades on a registered exchange, and (4) show that the unregistered Forex boiler room was the counter-party with whom the small investors traded. Under the CFMA, a Forex boiler room's failure to register with the CFTC automatically creates a de facto unregistered trading association subject to CFTC jurisdiction.[92] The greatest evidence of fraud is, of course, millions of dollars of losses, which unsurprisingly re-appear as profits for the Forex boiler rooms and its principals.

D.

[93] The Ninth Circuit in CFTC v. Co-Petro Marketing Group, Inc.[94] adopted the multi-factor test as an "appropriate methodology for determining whether a contract was a future or forward contract." Years later, in CFTC v. International Financial Services, the Southern District of New York held that the multi-factor test provides a framework for assessing a transaction "with a critical eye towards [the transaction's] underlying purpose" to determine the true nature of a transaction: whether it is for investment or to defraud unsophisticated small investors.[95] In light of the Southern District of New York's willingness to engage in a very fact specific analysis to uncover the "true nature" of the Forex trades between International Financial Services and the unsophisticated small investors with whom the trades were entered, it makes the ruling in Zelener even more difficult to comprehend and accept. Congress' intent in establishing the Treasury Amendment was never meant to apply in transactions where unsophisticated small investors were being defrauded. The Treasury Amendment was only to apply in the inter-banking market.

The multi-factor test designed by the CFTC consists of several factors including whether the contract is: (1) for the future purchase or sale of a commodity at a price agreed upon at the initiation of the transaction, (2) standardized as to terms and conditions other than price, and (3) undertaken primarily to assume or shift price risk rather than the transferring of the underlying commodity.[96] If a futures contract exists, then the CFTC has jurisdiction over the Forex transaction, and may commence an enforcement action against the Forex boiler room entity and its principals. If a forward contract exists, then the Treasury Amendment excludes the transaction from the CFTC's jurisdiction, and the CFTC may not commence an enforcement action against the Forex boiler room. However, what is not clear is whether the CFTC may commence an enforcement action when a Forex boiler room uses manipulative sales techniques to coerce unsophisticated small investors into entering an ultimately fraudulent transaction.

The Treasury Amendment allows OTC trading of a wide range of financial instruments by exempting these transactions from regulation.[97] In fact, the Treasury Amendment's purpose was to exempt certain Forex transactions from CFTC jurisdiction. In 1998, the Supreme Court in CFTC v. Dunn held that the Treasury Amendment exempted options from the CFTC jurisdiction because the phrase "transaction in foreign currency" meant all transactions including options.[98] The CEA previously exempted spot contracts and forward contracts from CFTC jurisdiction.[99]

Despite numerous amendments to the Treasury Amendment, the scope of the Amendment remains ambiguous. It is unclear whether the Amendment applies to speculative individual traders, such as sophisticated professional investors, or simply institutional investors who regularly participate in the inter-bank market. Currently, the ambiguity regarding the Treasury Amendment and the CFMA remains over whether a Forex contract offered to small investors is a forward or futures contract. How one distinguishes such contracts and whether a fraud on the market triggers CFTC jurisdiction are issues that have created contrary judicial decisions and hindered CFTC enforcement actions. For instance, if a contract is determined to be a futures contract, the CFTC has jurisdiction and may commence an enforcement action against an illegal Forex boiler room. However, if a contract is determined to be a forward contract, the CFTC has no jurisdiction and may not commence an enforcement action against the Forex boiler room. The litigation that has ensued during the past three decades since the Treasury Amendment's adoption evidences that neither the Treasury Amendment nor the CFMA have been accepted as a clear statement on the status of the law.[100]

E.

[101]

The Supreme Court outlined the framework [102] In Howey, the Supreme Court held that an interest in something is a "security" only if three elements are concurrently present: (1) an investment of money, (2) in a common enterprise, and (3) the expectation of profits solely from the efforts of the promoter or a third party.

The facts in Howey are as follows. The Howey Company, a Florida corporation, ("Howey") sold small tracts of land in a citrus grove to local purchasers. The purchasers lacked the knowledge, skill, and equipment necessary for the care and cultivation of citrus trees. The purchasers were free to service the tracts themselves or contract with a number of companies to service the tracts for them. The sales contract stressed the superiority of a Howey-related service company, Howey-in-the-Hills Service, Inc. ("Howey Hills"), which 85% of the purchasers chose to hire to service their respective tracts. The service contracts granted Howey Hills full and complete possession of the land. Individual purchasers had no right of entry to market the crop, but shared in the profits of the enterprise, which was approximately 20%. Howey did not register the interests in the enterprise as securities under the Securities Act of 1933.

The SEC brought an action to enjoin the sale of the citrus grove interests, even though the interests at issue did not constitute any of the specific, traditional kinds of securities enumerated in Section 2(a)(1) of the 1933 Securities Act. The SEC argued that the purchasers' interests in the expected profits were "investment contracts." While Congress had not yet defined the term "investment contract," the term was already in several state blue sky laws.[103] The Supreme Court adopted the definition used by most state courts, holding that an investment contract is a security under the 1933 Securities Act if investors purchased the investment contracts with: (1) an expectation of profits arising from, (2) a common enterprise, which (3) depends "solely" on the efforts of others for its success. The Supreme Court applied the "economic realities" analysis, and found that the interests in the citrus grove sold by Howey were "investment contracts" and, thus securities, subject to the registration requirement of the 1933 Securities Act. As a result, the SEC could commence an enforcement action to enjoin the sale of the unregistered land interests. The concept of "common economic interest" received a multitude of split decisions among the circuit courts following the Howey decision. In United Housing Foundation, Inc. v. Forman,[104] the Supreme Court determined whether shares of stock entitling a purchaser to lease an apartment in a state-subsidized and supervised nonprofit housing cooperative were "securities" within the meaning of the 1933 Securities Act and the 1934 Exchange Act. [105] The United Housing Foundation argued that the sole purpose of acquiring shares of stock was to enable low and moderate-income families to purchase and occupy an apartment in the cooperative. No voting rights attached to the shares, nor could the shares be transferred, pledged, or otherwise encumbered like traditional stock. If the owner-tenant vacated the apartment, the cooperative repurchased the shares at cost. The shares represented a recoverable deposit on the apartment, and did not provide an expectation of return on the investments.

After the housing cooperative raised rental charges, the residents sued the cooperative under Section 17(a) of the 1933 Securities Act, asserting that the cooperative falsely represented that it would bear all subsequent cost increases. The Supreme Court held that the stock issued by the cooperative was not a "security" because the shares lacked the five most common features of stocks: (1) the right to receive dividends contingent on an apportionment of profits, (2) negotiability, (3) the ability to be pledged, (4) voting rights in proportion to the number of shares owned, and (5) the ability to appreciate in value based substantially from the efforts of third-parties. The Supreme Court rationalized that the purchasers obtained the stocks to acquire subsidized housing, not to invest for profit, and thus the shares were not securities within the purview of the federal securities laws. Thus, Forman illustrates that the Howey test should be applied in light of "the substance-the economic realities of the transaction-rather than the names that may have been employed by the parties, to describe the Transaction is determinative."[106]

These cases and the statutory definition of a security identify an extensive list of financial instruments; however, they do not include the financial instruments typically involved in Forex transactions. This is a problem when the SEC attempts to assert jurisdiction over Forex transactions. As the Supreme Court stated in Marine Bank v. Weaver,[107] the definition of "security" under the Securities Exchange Act of 1934 is "quite broad." The Marine Bank court noted, "many types of instruments [sic] fall within the ordinary concept of a security." These include "stocks and bonds, along with the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits."[108] Thus, federal securities laws define "security" in both specific terms (any "stock," "bond," "note," "debenture") and general terms (any "investment contract" or "instrument commonly known as a "security"). The Supreme Court suggested that "instrument commonly known as a security" and "investment contract" have the same meaning for purposes of the 1933 Securities Act and the 1934 Exchange Act.[109] However, despite the broadness of the definition, Forex transactions are not securities because they do not satisfy the characteristics of a security as set forth in Howey.

The definition of a security has successfully applied to several non-traditional securities, including virtual shares. In SEC v. SG Ltd.,[110] the First Circuit held that "virtual shares" in an internet game were securities. The defendant operated StockGeneration.com, a website where visitors could buy "virtual shares" in "virtual companies" on a "virtual stock exchange." The website indicated that the game would generate one "privileged company" whose shares would constantly increase in value by 10% each month. Participants had to pay real money to buy virtual shares, and if the participants referred new players to the site, they would receive a percentage of the new players' payments.[111] The SEC brought an enforcement action against StockGeneration Ltd., claiming that the virtual shares were Howey-type investment contracts. The district court dismissed the action because the game was a lottery and not a common enterprise. The First Circuit reversed, finding the requisite "horizontal commonality" in the pooling of participants' funds. Horizontal commonality requires a pooling of investor contributions and distribution of profits and losses on a pro-rata basis among investors.[112] StockGeneration, Ltd. had no other source of funds to pay: (1) the guaranteed increase in value of shares of the privileged company, and (2) the fees to participants who referred new players to the game, other than the money that the new players paid to participate. Vertical commonality is less stringent, though some courts require a "strict" vertical commonality, insisting that there be a direct relationship between the promoters' financial success and that of the investors,[113] while others allow for "broad" vertical commonality, requiring only that "the fortunes of investors be tied to the fortune of the promoter."[114]

The First Circuit, in SEC v. SG Ltd.,[115] emphasized that the term "investment contract" embodies a "flexible rather than static principle" and that "form was disregarded for substance."[116] Subsequent decisions have modified the third prong of Howey from "solely" to "substantially." For an investment to be deemed a security, Howey requires that the expectation of profits from the investment come "solely" from the efforts of others; courts have interpreted "solely" to mean "predominantly," recognizing that if "solely" were construed literally, the slightest effort on the part of the investor would frustrate the remedial purposes of the federal securities laws. In SEC v. SG Ltd., the efforts of participants to recruit new players to the game would have been fatal to finding an investment contract if the court had construed "solely" literally.

Thus, in SEC v. Glenn W. Turner Enterprises, Inc.,[117] the Ninth Circuit held that the appropriate question for determining the application of "solely" was "whether the efforts made by those other than the investor are undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise?"[118] This interpretation builds on Howey's premise that form is not dispositive; substance also matters when identifying the existence of a "security." Likewise, when instruments used in Forex transactions do not fall plainly within the usual concept or definition of "stock," "note," "bond," "debenture" or "evidence of indebtedness," federal courts must consider whether these instruments would otherwise be deemed "securities" for purposes of Section 2(a)(1) of the 1933 Securities Act.

The Supreme Court's analysis of a traditional stock, in a non-traditional context, is instructive for determining the expansiveness of the definition of a security as it relates to Forex transactions. In Landreth Timber Co. v. Landreth,[119] the Supreme Court determined whether a single individual who purchased 100% of the stock in a lumber company and retained active management of the acquired business, could state a claim under the securities law for fraud in the sale of the business. The Ninth Circuit found that in acquiring control of the company, the purchaser was buying a business rather than a security. Thus, the court held that the sale of 100% of a closely held company was not a transaction involving a "security." Rather, it falls within the "sale of business" doctrine.[120]

The Supreme Court reversed, rationalizing that it would be burdensome to apply the Howey test to transactions involving "traditional" stock. The Supreme Court held that when a transaction involves the sale of an instrument called a "stock," and the stock bears the five attributes of a stock enumerated in Forman, federal securities laws govern the transaction. A traditional stock is so "quintessentially a security" and "plainly within the statutory definition" that application of the Howey test is unnecessary.[121] In Landreth, the Supreme Court determined that the Howey test was proper to determine whether a particular instrument that is not clearly within the definition of "stock," is an "investment contract" or an "instrument commonly known as a security." The test is whether "the scheme involves an investment of money with profits to come solely from the efforts of others."[122] The Howey test, as explained by the Supreme Court in Forman,[123] embodies the essential attributes that run through all of the Supreme Court's decisions defining a security.

If the Howey test is applied to Forex transactions, it is clear that the Forex transactions are not an "investment contract" or other "instrument commonly known as a "security" as defined in Section 2(a)(1) of the 1933 Securities Act. While there is an expectation of profit, (1) the expectation of profit is not based substantially on the efforts of a third party, (2) the investment is not part of a common enterprise, (3) there are no voting rights, and (4) the contracts cannot be pledged. As such, Forex transactions, in particular forward and futures contracts, are not securities and fall beyond the jurisdiction of the SEC.

[124]

Participants in the Forex market trade financial instruments called derivatives.[125] According to Judge Feinken, the derivatives market is a "financial Jurassic Park" because market participants are unable to quantify or control the effect of derivative losses on the financial market.[126] The Forex market is not an arena for unsophisticated small investors, but one for governments, banks, institutional investors, multi-national corporations, and sophisticated professional investors who have the acumen to speculate and withstand the volatility in the financial market.[127]

The Forex market participants play an integral role in the international economy, trading an estimated $1.3 trillion of currency daily.[128] Forex transactions influence global exchange rates that affect the world's financial markets and the global economy.[129]

[130]

Confusion exists over which federal regulator should regulate the Forex market. As discussed earlier, when the Treasury Amendment was adopted, the Treasury Department was primarily concerned with the inter-bank market, a market occupied by banks, institutions, and sophisticated professional investors. However, the scope of the Treasury Amendment is ill-defined. The CFMA replaced the Treasury Amendment. As the law currently exists, the CFMA excludes certain market participants and transactions in the Forex market completely from CFTC regulation. The confusion is whether Congress intended to exclude only institutional and sophisticated professional investors from CFTC jurisdiction when it promulgated the Treasury Amendment, or whether Forex boiler rooms and their activities fall within the scope of the Treasury Amendment exclusion. The Treasury Amendment excludes the CFTC from asserting jurisdiction from Forex transactions between eligible contract participants, FCMs, broker-dealers, and sophisticated professional investors whose Forex trades do not occur on an organized exchange. Presumably, the CFTC maintains jurisdiction over all other participants in the Forex market, especially unsophisticated small investors whose trades were not on an organized exchange. However, it is unclear whether the CFTC maintains jurisdiction when the transaction between unsophisticated small investors and a Forex boiler room, whose principals are sophisticated professional investors, does not occur on a registered exchange. Congress attempted to address this gap in the regulation when it adopted the CFMA and modified the definitions of the term "board of trade" and "organized exchange" to include off-exchange trades, or trades which occur on an unregistered association.[131]

Prior to the adoption of the CFMA, Forex boiler rooms utilized the ambiguity in the definitions and the Treasury Amendment exclusion to enter into Forex trades that were not conducted on a CFTC registered board of trade (commonly referred to as off-exchange trades) with unsophisticated small investors to successfully argue that the CFTC lacked jurisdiction.

[132] Therefore, Forex boiler rooms that trade off-exchange and fail to register with the CFTC are in violation of CFTC regulation. For jurisdictional purposes,[133] the trades are viewed as if they occurred on a board of trade permitting the CFTC to assert jurisdiction.[134] As such, Forex boiler rooms engaged in a trading platform that has not been designated or registered with the CFTC are known as Type II boiler rooms. Type II boiler rooms avoid prosecution by drafting futures contracts to appear as if they are forward contracts. They obtain legal opinions from counsel that opine as to the legitimacy of the contract as forward contracts. When the CFTC attempts to commence an enforcement action against a Type II boiler room, the Type II boiler room challenges CFTC jurisdiction by raising numerous legal defenses that track the ambiguity in the definitions of the term "board of trade" and "organized exchange" to effectively prevent the CFTC from asserting jurisdiction.[135]

Despite jurisdiction enhancing modification to the CFMA, Type II Forex boiler rooms continue to vigorously defend their fraudulent trades as legal, arguing that Forex boiler rooms existed prior to the adoption of the CFMA.[136] Accordingly, Forex boiler rooms argue that the CFMA should not be applied retrospectively. Thus far, this has been a winning defense for several cases.

One Forex boiler room successfully argued before the Seventh Circuit that the transactions between them and their unsophisticated small investor clients were forward contracts and not futures contracts, irrespective of the fact that no trades occurred on a registered exchange. The Seventh Circuit's recent decision in CFTC v. Zelener[137] upheld a defense that transactions with unsophisticated small investors were not futures contracts because terms were non-fungible-negotiated terms. As such, the court prohibited the CFTC from commencing an enforcement action.[138] Furthermore, the Seventh Circuit rejected CFTC's multi-factor test to determine whether a Forex contract is a futures contract or forward contract because the multifactor test "is too complicated."[139]

The decision in Zelener is shocking. It galvanized Congress to amend the Treasury Amendment yet again, by modifying the CFMA to close the loopholes in the statute. As of this writing, the Senate Committee on Banking, Housing, and Urban Affairs is holding hearings on what has been labeled as the "Zelener factor." Part of the Congressional discussion will undoubtedly focus upon the unintended result of the Zelener decision and the need for greater regulation to prevent exempted institutional investors from inadvertently entering into Forex transactions with small investors vis-à-vis Type II Forex boiler room transactions.

[140]

Recent studies stress the importance of internal controls and risk management procedures.[141] These studies provide practical proposals for derivatives dealers and investors in the area of internal controls and senior management oversight. Perhaps the most notable study is the Group of Thirty, which provides several sound guidelines of risk management and internal controls.[142] International initiatives, such as Barings[143] have failed to promote sustainable international regulatory coordination for exchange-traded derivatives.[144] Sixteen international securities and futures regulators entered into the Windsor Declaration in an attempt to coordinate regulatory efforts.[145] Furthermore, the Technical Committee of the International Organization of Securities Commissions and the Basle Committee on Banking Supervision issued white papers providing guidance to the securities and Forex regulators on risk management for derivative activities.[146] The Futures Industry Association coordinated a global Task Force on financial integrity, which issued recommendations geared towards enhancing and protecting the assets of Forex market participants.[147] These recommendations attempted to improve cross-border coordination and communication among exchanges clearinghouses and regulators.[148] Of course, Congress needs to clarify U.S. laws regarding Forex transactions and provide guidance as to CFTC and SEC jurisdiction in the foreign currency market.[149]

[150] If the transaction is a futures contract or an option, the CFTC regulates the transaction. As discussed later, futures contracts, forward contracts, and options are not securities because they do not meet the element in Howey defining a security. As such, options, futures, and forward contracts are outside of SEC regulation. The CFTC regulates futures contracts and commodity options. However, forward contracts and financial instruments possessing the attributes of an investment contract[151] are outside of CFTC regulation.[152] Interestingly, forward contracts are not per se regulated, but participants who trade them presumably fall within the purview of the following federal regulators: (1) the Federal Reserve and the Treasury Department regulate the participants if they are banks, or (2) the SEC regulates the participants if they are broker-dealers or publicly traded companies. Within this apparently prominent list of federal regulators is still one that is missing, the CFTC.

The CFTC has no jurisdiction in the forward market. This lack of regulation by the CFTC, in part, can be traced back to the exemption under the Treasury Amendment. This exemption continues under the CFMA, in part, because of the Forex industry's powerful lobbying efforts. Lobbyists have consistently convinced Congress that federal regulation of the forward market by the CFTC is unnecessary because Forex market participants are institutional investors and sophisticated investors, who fall within the regulative authority of other federal entities. Additionally, lobbyists have convinced Congress that regulation would jeopardize the liquidity and efficiency of the Forex daily market. Despite lobbyists' relentless efforts to prevent CFTC regulation in the forward market, the CFTC has commenced enforcement actions when Type II Forex boiler rooms defraud the public and other federal regulators are unable or unwilling to assert jurisdiction. The CFTC's enforcement actions against Type II Forex boiler rooms have resulted in increased financial internal control and risk management analysis by institutional investors. Institutional investors implement several measures to ensure that they are not unwittingly trading with small investors who are financially unable to borne the potential losses associated with Forex transactions.[153] In an effort to contract regulation on a global level and to coordinate regulatory oversight of these varying jurisdictions, several international initiatives have been commenced via tri-lateral agreements between the SEC, CFTC, and the U.K. Department of Trade and Industry.[154]

E.

[155] The SEC enforcement actions typically allege that a Type II Forex boiler room and its principals engaged in a deliberate scheme to defraud investors by making false and misleading statement to induce small investors to make trades in the Forex market.[156] The SEC typically alleges that a Type II Forex boiler room used illegal marketing sales tactics including aggressive cold calling, internet websites, television infomercials, paid radio advertising, and misleading brochures.[157] The SEC complaints usually charge the Type II Forex boiler room and its principals with violations of Sections 5(a), 5(c) and 17(a) of the 1933 Securities Act, Section 10(b) of the 1934 Securities Exchange Act, Rule 10(b)-5, and Section 15(a) by acting as unregistered brokers. The SEC also typically requests: (1) preliminary and permanent injunctive relief, (2) an accounting and disgorgement of profits with prejudgment interest, and (3) the imposition of civil money penalties against the Type II Forex boiler room and its principals.[158] However, the permanent injunction is simply against the Forex boiler room, which means the principals of the Type II Forex boiler room are free to re-establish a new Type II Forex boiler room within weeks of closing down.[159]

[160] in an effort to assert jurisdiction.[161] There are two critical features of the nature of Forex derivative instruments: (1) the subject matter or type of financial instrument and (2) the operation or how it works. The various judicial interpretative definitions partially stem from the CFTC's need to remain abreast of ever-changing classifications and categories of financial instruments that fall within the category of derivatives or foreign exchange.

The CFTC's effort to regulate this trillion dollar global industry has been difficult. Financial instruments are illusive products because they are constantly changing in terms of their subject matter and operation. Oftentimes, a few carefully crafted terms, or the lack thereof, may remove a transaction from the CFTC's jurisdiction. The illusive nature of Forex financial instruments makes it extremely difficult to regulate and to commence enforcement actions. The CFCTC must balance this constant tension between competing interests and goals. On one hand, the CFTC must maintain the integrity and flexibility of the forward contact market in which trillions of dollars of legitimate transactions occur on a daily basis. Simultaneously, it must commence enforcement actions against Type II Forex boiler rooms that defraud the public of millions upon millions of dollars.[162] These competing interests and goals have become major challenges for the CFTC.

During the past ten years, the CFTC has seen a steady increase of unregistered and unregulated entities engaging in questionable and, oftentimes illegal, sales practices and financial fraud in connection with off-exchange trades. More disturbingly, these Type II Forex boiler rooms have succeeded in evading prosecution by raising several defenses, which are mirror images to the definitional disputes between the CFTC, SEC, Federal Reserve and the Treasury Department. The defenses raised by Type II Forex boiler rooms to evade enforcement actions are: (1) the trades are not "transactions in foreign currency," they are "options" in foreign currency, (2) the trades were not on an "organized exchange," they were on an unregistered association's proprietary "board of trade," not an official exchange registered with the CFTC,or (3) the trades are not futures contracts, they are forward contracts. These defenses are effective, and Congress and the courts have responded by redefining terms and engaging in proactive analyses to find that CFTC jurisdiction exists. The courts, however, have struggled to find practical definitions. In the recent CFTC v. Int'l Financial Services decision from the Southern District of New York, a Type II Forex boiler room claimed that the Treasury Amendment exempted the CFTC from asserting jurisdiction. The Forex boiler room argued that the Forex transactions that International Financial Services ("International Financial") executed for its clients did not qualify as futures contracts over which the CFTC possessed jurisdiction, and that the trades were not conducted on an organized "board of trade."[163]

The facts in CFTC v. Int'l Financial Services are worth briefly discussing. International Financial required its brokers to buy and sell foreign currency futures contracts at artificially inflated prices provided by International Financial's "clearinghouse." The "clearinghouse" was actually a principal of International Financial. The Southern District of New York reasoned that the exclusive relationship between the principal and International Financial left the clients captive to International Financial's pricing and placed the clients at a great disadvantage.[164] The court further stated that the brokers made money exclusively through commissions generated by the trades, giving them perverse incentives to "buy and sell" at prices they knew would result in virtually certain losses for their customers.[165]

Furthermore, International Financial instructed its brokers to employ "illogical and overly risky" trading strategies that would have been disastrous even had International Financial legitimately been clearing trades through its "clearinghouse."[166] The Court rationalized that while International Financial clearly did not operate a formal, authorized exchange, it nonetheless operated a "board of trade."[167] The Court further analyzed that the phrase "conducted on a board of trade" encompasses more than just transactions conducted on formally organized futures exchanges. It also encompassed trades that were made off-exchange, as long as the transactions were not conducted between two banks." [168]

The Court rejected International Financial's defense that the Treasury Amendment exempted its activities from CFTC jurisdiction because International Financial's trades occurred off-exchange.[169] This type of judicial interpretation is necessary if the intent of the Treasury Amendment and CFMA is to be satisfied while simultaneously allowing the CFTC to assert jurisdiction over Type II Forex boiler rooms that defraud the public. However, a federal appeals court decision has rekindled a long-standing definitional dispute among the CFTC, the Treasury Department,[170] and the Supreme Court. The Supreme Court resolved these jurisdictional disputes in the Dunn v. CFTC decision, but the Supreme Court may likely intervene again.

The jurisdictional disputes stem in part from the CFTC's broad interpretation of the terms "transactions in foreign currency," "board of trade," and "futures contract." The Supreme Court decision in Dunn resolved the definition of "transaction in foreign currency." The tortured development and varied applications that led to the Dunn decision will be discussed in Part IV. The definitional dispute of the "term board of trade" was finally resolved in Lehman Bros. Comm. Corp. v. Minmetals Int'l Non-Ferrous Metals Trading Co.[171] The tortured development and varied applications that led to the Lehman Bros. Comm. Corp. v. Minmetals Int'l Non-Ferrous Metals Trading Co. will also be discussed in Part IV. The definitional dispute of the term "futures contract" remains unresolved. More specifically, "[n]o statute . . . defines 'futures contract.'"[172] This is precisely why the Seventh Circuit's decision in CFTC v. Zelener,[173] which struck down the CFTC's multi-factor test that determines when a futures contract exists, is so troubling. Part IV discusses the development of the multi-factor test and the markets response to the Zelener decision.

The CFTC, in an effort to distinguish futures contracts[174] from forward contracts[175] or spot contracts,[176] designed a multi-factor test.[177] The multi-factor test determines whether a futures or forward contract exists by reviewing the terms of a contract to determine whether the contract is: (1) for the future purchase or sale of a commodity at a price agreed on at the initiation of the transactions, (2) that is standardized as to terms and conditions other than price, and (3) undertaken primarily to assume or shift price risk rather than the transferring of the underlying commodity.[178]

[179] and hybrids.[180] However, in 1994, as an outcome of the Gibson Greetings[181] matter, federal regulators worked in tandem to commence enforcement actions. The Federal Reserve Board,[182] the SEC, and the CFTC negotiated consent decrees with Bankers Trust and BT Securities ('BT Securities") that were virtually identical.[183] The SEC charged BT Securities with causing Gibson Greetings to file inaccurate financial statements.[184] The SEC charge was an innovative way to regulate Forex transactions without necessarily regulating the Forex instrument itself.

As we discussed earlier, the SEC has jurisdiction only over security instruments. If a financial product is not a security, the SEC is void of jurisdiction. The definitional, jurisdictional lines at first blush appear to be clear and unambiguous. However, the question remains as to what happens when a financial product is a hybrid-that is, has elements of a commodity and a security instrument? Who may regulate the transaction? A critical factor for the future will be whether the federal regulators may effectively assert jurisdiction over the same legal terrain. In the case of Gibson Greetings, the SEC and CFTC both filed and settled administrative proceedings against BT Securities, alleging violations of federal anti-fraud provisions, federal securities laws, violation of the CEA, and CFTC rules.[185] At the time, in 1994, this type of "team" enforcement action was quite innovative and would later serve as the predicate for the dual jurisdictional grant to the SEC and CFTC under the CFMA.

The CFTC and SEC simultaneously asserted jurisdiction over BT Securities alleging violations of fraud under their respective rules. This was the first time in history that both federal regulators asserted jurisdiction over the same entity for the same transaction.[186] First, the CFTC asserted the narrowest theory of jurisdiction, the CFTC charged that due to BT Securities' role as a trusted and confidential advisor to Gibson Greetings, BT Securities was a "commodity trading advisor" and any fraudulent statement or misrepresentations violated the CEA.[187] Second, the SEC asserted jurisdiction, alleging that at least one interest rate swap sold by BT Securities was an option on a security and not a commodity, which triggered the SEC's enforcement authority. The interest rate swap was a derivative transaction known as a treasury linked swap. A treasury linked swap is a "cash settled put option that was written by Gibson Greetings."[188] As such, the SEC determined that fraud in connection with the purchase or sale of a security existed, and BT Securities violated the anti-fraud provisions of the federal securities laws.[189] The SEC adopted a broader approach than the CFTC by finding that the instrument was a security before the SEC asserted jurisdiction.[190]

The SEC's approach was innovative and effective. The media actively reported upon the Gibson Greetings situation. The public was amazed that a sophisticated institutional investor like Gibson Greetings could have been misguided by its investment advisor. One factor that affects the public's view of derivatives and, to a certain extent the courts' view, are highly publicized losses. In the early 1990s, derivatives caused multi-million dollar losses by corporations, mutual funds and institutional investors.[191] During the mid-to-late 1990s, several derivative transactions received public scrutiny and criticism for the failed and massive losses experienced by municipalities, companies and hedge funds. Notably, Orange County, CA and Long Term Capital required a Federal Government bailout because of the potential market impact of a one billion dollar loss. This led the CFTC to recommend regulation of the OTC derivatives market.

However, the true bases of these losses were sharp increases in interest rates, volatility of the currency exchange rates and energy prices.[192] Nonetheless, companies that experienced decline in profits or net asset value commenced lawsuits against investment companies, alleging that they were misled as to the level of risk associated with the investment derivative.[193] The complaints also alleged violations of anti-fraud provisions of the federal securities laws, common law fraud, negligence, and breach of fiduciary duty.[194]

To date no court has found the sale or purchase of swaps, futures, or commodity options violates the federal securities laws, state Blue Sky Laws, or common law fraud.[195] As we discussed earlier, in 1994, the SEC and the CFTC negotiated consent decrees with BT Securities as an outcome of the Gibson Greetings matter. However, there was never a complaint filed in federal court because BT Securities complied with the consent decrees, and the possibility that a lawsuit would commence against BT Securities became moot.

[196]

The Forex industry historically interpreted the Treasury Amendment as exempting exchange-traded transactions involving foreign currencies from regulation.[197] The issue is whether the Treasury Amendment, and the CFMA are really meant to exclude: (1) all "transactions in foreign currency," (2) transactions not traded "on a board of trade or organized exchange," and (3)all forward contracts from CFTC jurisdiction. Judicial interpretations of Congress' intent regarding these issues have not been consistent. Different circuit courts have construed Congress' intent differently. The most problematic judicial decision was made by the Seventh Circuit in Zelener. Although the Zelener decision probably would have reached the Supreme Court, the CFTC did not appeal the Seventh Circuit's decision. Historically, Congress has intervened on numerous occasions when ambiguity in statutory interpretation exists to makes its own intent clear.[198]

The Treasury Amendment Letter[199] excludes "transaction in foreign currency" from CFTC regulation unless the trade occurred on an organized exchange. The Treasury Amendment repeatedly expressed concern for "banks and other institutions."[200] The Treasury Department's letter to the Senate Committee on Agriculture and Forestry, concerning the inter-bank market, referred to an "informal network of banks and dealers" and that over regulation by the CFTC would have "an adverse impact on the usefulness and efficiency of foreign exchange markets for traders and investors."[201] The Treasury Letter appears to distinguish between participants involved with organized exchanges and investors on informal OTC off-exchange traders. Congress responded to the Treasury Department's request by enacting the Treasury Amendment. [202]

The specific text of the Treasury Amendment[203] allows for a literal reading of the statute, but could also allow a court to interpret it as prohibiting CFTC jurisdiction not only: (1) to banks and institutions, (2) but also to sophisticated individuals who participate in the Forex market, or even to Forex boiler rooms whose sole purpose is to defraud the general public. These are precisely the issues to be resolved: what is the breadth of the Treasury Amendment and CFMA as to whether (1) all "transactions in foreign currency," (2) transactions not traded "on a board of trade or organized exchange," and (3) all forward contracts are excluded from CFTC jurisdiction.

[204] At the time, the newly created hybrid financial instruments likely to have been misinterpreted as futures contracts triggering the CFTC's jurisdiction were the Government National Mortgage Association ("GNMA") forward contracts.[205] GNMA buys "mortgages from lending institutions, securitizes them, and then sells them to investors" in a secondary market.[206] The purpose of these securities is to attract new capital to the primary market, which allows lenders to provide a greater amount of financing for home mortgages. In Abrams v. Oppenheimer,[207] the Seventh Circuit held that the legislative history of GNMA contracts did not constitute futures contracts, and were outside the scope of the CFTC jurisdiction.

The analysis that the Seventh Circuit underwent in Abrams v. Oppenheimer, assisted in developing the CFTC's multi-factor test to determine whether a financial contract was a futures or forward contract. It is, therefore, quite interesting that the Seventh Circuit in CFTC v. Zelener struck down the CFTC's multi-factor test, which is the same test that the Seventh Circuit assisted in developing approximately 20 years earlier in Abrams v. Oppenheimer.

In Abrams v. Oppenheimer, although the GNMA contracts resembled futures contracts, they were actually forward contracts. The Seventh Circuit relied upon the following factors to determine when a financial contract is a futures contract: (1) the GNMAS contracts were individually negotiated and non-standard contracts, (2) the purchaser often takes actual delivery of the underlying commodity, and (3) the GNMA contracts were not traded on a contract market.[208] The CFTC issued a statutory interpretation seeking to narrow the Seventh Circuit's interpretation of the Treasury Amendment, stating that off-exchange trades in financial instruments are within the Treasury Amendment's exclusion only when all the participants are "sophisticated and informed participants."[209]

[210] The CFTC argued that its interpretation was narrowly tailored and did not seek to assert jurisdiction in all forward contracts; only in situations where the public has been defrauded. As such, the Treasury Amendment's purpose was not to exclude participants who commit fraud from the CFTC's jurisdiction.[211] In response, both the Federal Reserve Board and the Treasury Department protested and the CFTC relented by withdrawing its statutory interpretation, even though the Second Circuit had already ruled that the CFTC was correct as a matter of law.[212]

[213] established the "sophisticated trader" paradigm. The court held that an individual trader is liable for his Forex trading liability if he is a sophisticated trader.[214] The Fourth Circuit ruled that the Treasury Amendment included participants in the Forex inter-bank market as "sophisticated traders." As such, individuals who participate in the Forex inter-bank market are sophisticated traders and their Forex transactions are exempt from CFTC jurisdiction.[215] Thus, options, puts, and calls traded OTC by sophisticated traders are exempt from the CFTC jurisdiction because of the Treasury Amendment.[216] Of course, this analysis imposes liability on unsophisticated small investors defrauded by a Forex boiler room by upholding the investors' trading liability, irrespective of the Forex boiler room's fraudulent conduct. Furthermore, the Salomon Forex v. Tauber[217]ruling prohibited the CFTC from commencing an enforcement action against Forex boiler rooms.

The lower court in Salomon Forex v. Tauber, the Eastern District of Virginia, held that the Treasury Amendment exemption was not solely restricted to the bank market.[218] The Court refused to modify its statutory interpretation in accordance with the legislative history of the CEA and the Treasury Amendment.[219] The Court reasoned that transactions in foreign currency "plainly and unambiguously" included futures and options. The legislative history restricting the exemption solely to banks and institutions was irrelevant.[220] As a result, the Court broadly applied the Treasury Amendment exemption to include sophisticated individuals that traded in the Forex market. The Supreme Court would refer to the Salomon Forex v. Tauber analysis when it decided Dunn in the late 1990s.

On appeal, the Fourth Circuit affirmed the district court's ruling, but the analysis focused upon the interpretation of "transactions in foreign currency" and the traders included in the inter-bank market.[221] The Fourth Circuit enumerated the principles of statutory construction to determine conclusively Congressional intent.[222] The Fourth Circuit construed the phrase "transactions in foreign currency" as broad and unqualified, allowing inclusion of futures and options within the language.[223] The Fourth Circuit reasoned that the "unless" clause contained within the statute limited the general clause.[224] Thus, "transactions in foreign currency" included all transactions in foreign currency.[225]

Furthermore, the Fourth Circuit reasoned that "transactions in commodities" referred to futures in other sections of the CEA.[226] Thus, "transactions in foreign currency" included options whenever the language appeared in the CEA.[227] The Fourth Circuit viewed options and forwards to be sufficiently similar for analytical purposes because: (1) neither transaction involves contemporaneous delivery, and (2) both transactions involve the purchase of a promise, that is, a contractual right which directly concerns the underlying subject matter.[228] Therefore, futures, forwards and options must be "transactions in foreign currency" because there is no "principled reason to distinguish between" these types of contracts.[229] Therefore, the Court ruled that a transaction is exempt from the CEA when the transaction occurs between "sophisticated, large scale foreign currency traders."[230] However, this analysis does not apply to mass marketing of futures, forwards, or options to the public.[231] Forex boiler rooms must comply with the CFTC rules and are subject to CFTC jurisdiction.[232]

[233] The Second Circuit held that buying and selling an option is "the 'right' to engage in a transaction, in the future, and until this right matured, there was no transaction because 'an option' is not an actual transaction," which can be exempted from CFTC jurisdiction.[234]

The decision concerned the securities industry, and on appeal, precipitated a flurry of amicus briefs to the Supreme Court. The Foreign Exchange Committee and the New York Clearing House both argued that permitting the CFTC the authority to regulate foreign exchange currency markets could result in the unenforceability of outstanding foreign exchange transactions.[235] Furthermore, the Supreme Court's ruling could impose large regulatory costs on the OTC Forex market, which could result in business fleeing overseas to more accommodating jurisdictions.[236] The CFTC v. Dunn decision was decided while the CMFA was pending, which instigated a flurry of financial news articles. Congress held hearings to determine the CFMA's potential impact on the market. Congress considered the concerns raised by the industry. Congress construed the CFMA to statutorily limit the impact on the Forex industry. This limitation also left open the statutory loopholes that would permit fraudulent activity to occur via the Forex boiler rooms.[237]

[238] It was, and remains, the CFTC's position that more regulation is needed for firms that defraud the public.[239] However, it is precisely this position that concerns the Forex industry.[240]

The Supreme Court's decision in Dunn places the jurisdictional debate and the concerns of many regarding regulation of the Forex industry to rest. The Supreme Court reversed the Second Circuit's position, holding that the Treasury Amendment exempted off-exchange trading in foreign currency from CFTC regulation.[241] The Supreme Court found that options clearly qualify as "transactions in foreign currency" within the meaning of the statute.[242] The Supreme Court did not discuss the issue regarding the interpretation of the term "board of trade" because the issue was not before the Court. The Supreme Court reversed the Second Circuit based upon the Second Circuit's "mis-interpretation" of the term "transactions in foreign currency." In Dunn, the Second Circuit interpreted the term "board of trade" as "on-exchange."[243] Judicial review of the term "board of trade" has not been widely interpreted by the courts. However, the Ninth Circuit had the opportunity to interpret the meaning of "board of trade in the CFTC v. Frankwell Bullion case."[244]

[245] The Ninth Circuit examined the legislative history of the term "board of trade" and determined that Congress intended that "transactions conducted on a 'board of trade" to mean "on-exchange trades."[246] For that reason, the Ninth Circuit interpreted the Treasury Amendment's "to exempt all off-exchange transactions in foreign currency" from CFTC jurisdiction.[247] However, the Supreme Court in Dunn did not resolve this fundamental issue because the definition of "board of trade" was not an issue before the court. The Dunn appeal granted by the Supreme Court regarding the Treasury Amendment focused on the scope of the phrase "transactions in foreign currency" and whether it included options.[248] Unfortunately, the Second Circuit did not explain how it arrived at such a distinction between on-exchange and off-exchange transactions. A logical explanation for the Second Circuit's conclusion is that it rationalized that a "board of trade" included only on-exchange transactions.

The Ninth Circuit in Frankwell held that the Treasury Amendment did not apply to transactions in foreign currency, unless the transactions involved a sale for future delivery conducted on a "board of trade." The Treasury Amendment exempted all off-exchange transactions in foreign currency from the CFTC's jurisdiction.[249] The CFTC attempted to close down Frankwell Bullion Ltd. ("Frankwell"), which was a Hong Kong based company that marketed currency-traded services to Chinese immigrants. The district court prevented the CFTC from taking action against Frankwell because of the Treasury Amendment (similar to the Seventh Circuit's holding in Zelener).[250] The impetus for the CFTC's action was to protect small investors that had unwittingly entered into Forex trades by purchasing foreign currency products that were inappropriately marketed to unsophisticated small investors. The CFTC was concerned that "unsophisticated investors will be victimized by dishonest traders."[251] However, the Ninth Circuit ruled that the CFTC had no authority to regulate "transactions in foreign currency" because the legislative history of the "Treasury Amendment" indicated that Congress intended to "exclude all off-exchange traded transactions from CFTC jurisdiction." [252]

The CFTC took quick and decisive action against Frankwell, which is a clear example of the underlying policy of all enforcement actions: Forex boiler rooms that defraud the public should unequivocally be subject to federal regulators' jurisdiction and enforcement actions.

The issue in CFTC v. Frankwell was whether Frankwell was a "board of trade."[253] The Ninth Circuit narrowly defined "board of trade," rationalizing that "where Congress has intentionally and unambiguously drafted a particularly broad definition, it is not our function to undermine the effort."[254] The Ninth Circuit stated that the legislative history indicates that Congress intended the Treasury Amendment to exclude all off-exchange transactions, with banks being the primary beneficiaries of the exemption.[255] In lieu of using the terms "on-exchange" and "off-exchange," Congress used the term "board of trade" which has a broader statutory definition.[256] Although, most cases concerning the Treasury Amendment have focused on the meaning of the term "transactions in foreign currency" rather than "board of trade," the Ninth Circuit agreed with the rationale from CFTC v. Standard Forex[257] that the term "board of trade" is ambiguous, thus necessitating an examination of the legislative history.[258] The Ninth Circuit defined "board of trade" to include both formally organized exchanges and informal associations of persons engaged in the business of buying and selling commodities."[259]

Furthermore, the Ninth Circuit believed that the CFTC was unlikely to prevail in the Supreme Court because the merits of the case did not support CFTC's position. More specifically, options were originally excluded from CEA jurisdiction because they were not viewed as transactions in the underlying commodity.[260] The term option was not specifically provided for in the Treasury Amendment because the term did not exist in 1974. Thus, Congress was not addressing options in the Treasury Amendment. But for exclusions to have any viable meaning, however, they must live and breathe to include new financial instruments as they are created in the marketplace.[261]

Yet, this analysis seems extremely familiar. In fact, this same analysis was used in Standard Forex and was touched upon in Dunn. Yet, even though other cases addressed this definition, Frankwell has great normative impact because few circuits have examined the meaning of the term "board of trade."

The Frankwell court fills the interpretive void that the Second Circuit created, reasoning that Congress intended the Treasury Amendment to exclude all off-exchange transactions in foreign currency with banks as the primary beneficiaries.[262] However, instead of using the terms "on-exchange" and "off-exchange," Congress used the term "board of trade, which has resulted in a certain level of ambiguity, which the CFMA addressed."[263]

The predominant view, set forth in Standard Forex,[264] held that when Congress enacted the Treasury Amendment, limiting CFTC jurisdiction regarding currency transactions "conducted on a board of trade," Congress intended "to exempt only inter-bank transactions that were already regulated by the banking regulatory agencies."[265] As such, the CFTC may take action against Forex boiler rooms that defraud the public because Congress did not intend to include Forex boiler rooms in with the scope of the Treasury Amendment.

At the time, the Frankwell decision prevented the CFTC from commencing an enforcement action against Forex boiler rooms. The decision raised the ire of the regulators, and the Forex industry alike.[266] The Chicago Mercantile Exchange denounced the decision and renewed its call for a legislative solution to close the loophole in the CEA. The Chicago Mercantile Exchange Chairman, Jack Sander, stated that the Frankwell "ruling is exactly the kind of disaster we feared . . . [it] reinforces the need for . . . Congressional action to ensure off-exchange bucket shops . . . are put out of business"[267]

[268]

In 1996, Congress considered the legislation regarding the CEA Amendments, introduced by Senator Richard Lugar and Senator Patrick Leahy. At issue were: (1) whether the CFTC has jurisdiction over the off-exchange transactions, (2) providing clarification regarding the exemptions for swaps transactions and audit trails, (3) permitting exchanges to operate less regulated basis for institutional and sophisticated professional investors, and (4) reducing CFTC review time for newly created Forex financial products. There was a lot of debate about whether the Forex market has proper regulations or whether the commodity exchanges are at a competitive disadvantage. The commodity exchanges used this opportunity to push for less regulation of the exchanges by pointing to the unregulated OTC market, while the CFTC simultaneously pushed for more regulation by pointing to the proliferation of Forex boiler rooms that defraud the general public.[269]

In 2000, Congress recognized the need to enable the CFTC to regulate fraudulent Forex activities that were costing unsuspecting small investors billions in losses. Congress adopted the CFMA.[270] The CFMA removed the legal uncertainty arising from the Treasury Amendment by repealing the Treasury Amendment and adopting new laws, which provide the CFTC with special enforcement powers "solely with respect to transactions that are futures or options on foreign currency."[271] The CFMA does not grant the CFTC jurisdiction over forward contracts, thus active and well-established cash and forward markets in foreign currency continue to fall outside of CFTC jurisdiction.[272] Nor does the CFMA grant the CFTC exclusive jurisdiction with respect to enforcement of futures or options on foreign currency, or pre-empt the jurisdiction of other applicable federal and state regulators. The SEC,[273] state securities commissions, or the offices of the state attorney general may commence enforcement actions against Forex boiler rooms that violate federal or state securities laws. As a practical matter, however, most state regulators refer cases dealing with Forex fraud to the CFTC.[274]

[275] the case because the Seventh Circuit stripped the CFTC of its Forex enforcement authority.

On May 2005, the Seventh Circuit, en banc, denied the CFTC's request to rehear the Zelener case. Although previously intending to appeal the Seventh Circuit's decision to the Supreme Court, the CFTC declined to pursue its appeal. The Seventh Circuit's decision was so disturbing that the Senate Committee on Banking, Housing, and Urban Affairs held hearings to examine the relevant provisions of the CFMA, and the unintended results of the Zelener decision on the market.

As mentioned earlier, the Supreme Court presumably resolved at least the one of the definitional disputes that had created judicial non-uniformity in the decision. In Dunn, the Supreme Court held that the Treasury Amendment[276] excluded from the CFTC's jurisdiction all "transactions in foreign currency. . . [including options] unless such transactions involve[d] the sale thereof for future delivery conducted on a board of trade."[277] As discussed in Part II, the Treasury Amendment is a letter that the Treasury Department, fearing regulation of the foreign currency market by the CFTC, forwarded to Congress in 1970 requesting an exemption from CFTC jurisdiction of transactions occurring in foreign currency.[278] The Treasury Department was primarily concerned with the inter-bank market, a market occupied primarily by banks and institutions, as well as sophisticated professional investors.[279] In the Treasury Department's letter to the Senate Committee on Agriculture and Forestry concerning the inter-bank market, it referred to "an informal network of banks and dealers" and expressed concern of "an adverse impact on the usefulness and efficiency of foreign exchange markets for traders and investors."[280] The Treasury Letter distinguishes between participants involved with organized exchanges[281] and informal OTC off-exchange traders. Congress responded to the Treasury Department's request by enacting the Treasury Amendment.

Several years later the CEA formerly defined "a board of trade" as "any exchange or association, whether incorporated or unincorporated, of persons who are engaged in the business of buying or selling any commodity or receiving the same for sale on consignment."[282] The breadth of the definition of "board of trade" include[d] both formally organized exchanges and informal associations of persons engaged in the business of buying and selling commodities, creating fear that "the 'unless' clause of the [A]mendment [had] threaten[ed] to swallow the whole."[283] The confusion regarding the term "board of trade," broadly speaking, concerns Congress' intent to exclude only banks, institutional investors, and sophisticated professional investors from the CFTC jurisdiction. If such is the case, then clear, statutory instruction is all that was necessary. Instead, the Treasury Amendment exempted "all trading on organized exchanges," including the inter-bank market.[284] If a trade occurred off-exchange, the CFTC has jurisdiction because the trade would not have been exempted by the Treasury Amendment, since only trades which occur "on a board of trade" or organized exchanged which is registered with the CFTC are exempt from CFTC regulation.[285]

The Treasury Amendment exempts not only banks and institutional investors from the jurisdiction of the CEA, but also "sophisticated financial professionals"[286] within the inter-bank market whose transactions are "traded on an organized exchange."[287] No other Forex participants, especially unsophisticated small investors whose trades occurred off-exchange, have exemptions from CFTC. Therefore, off-exchange trades are illegal and barred by the Treasury Amendment and the CFMA. Off-exchange trades are subject to the CFTC's jurisdiction because the Treasury Amendment and the CFMA specifically provide that parties who are not eligible contract participants (sophisticated professional investors) must "trade on an organized exchange."[288]

Many academics and practitioners mistakenly believe that the Supreme Court in Dunn resolved this issue of on-exchange, off-exchange trades. In Dunn, the Supreme Court discussed the definition of the phrase "transactions in foreign currency" to which it gave an ordinary and broad statutory reading and refused to adopt the CFTC's narrower reading of the phrase. The CFTC's reading defined the phrase "transactions in foreign currency," did not include options.[289] The Supreme Court disagreed and held that the Treasury Amendment completely bars foreign currency transactions from CFTC regulation, except to the extent that transactions are conducted on "a board of trade."[290]

The Supreme Court spent a great deal of time analyzing the phrases "transactions in foreign currency," and "futures contracts." However, the Supreme Court failed to interpret the phrase "board of trade." The CEA broadly defined the term "board of trade" as "any exchange or association, whether incorporated or unincorporated, of persons who are engaged in the business of buying or selling any commodity or receiving the same for sale on consignment."[291] The Supreme Court's oversight in failing to interpret the term "board of trade" continues to cause confusion as to what are legitimate trading platforms for Forex transactions, in which over $1 billion of trades occur on a daily basis, and who are the appropriate parties that may conduct such trades in the Forex market unfettered by federal regulators.

In August 2000, Congress attempted to resolve the confusion by adopting the CFMA,[292] which repealed the Treasury Amendment and granted, to the extent applicable, dual jurisdiction to the SEC and CFTC to commence enforcement action against Forex boiler rooms. Although, the CEA defines the term "board of trade" as an organized exchange, the CFMA has revised the definition to include unincorporated associations of buyers and sellers of commodities.[293] Despite this revision, crafty Forex boiler rooms avoid CFTC enforcement by arguing that the alleged fraudulent trades did not occur on an organized exchange and that the formation of the Forex boiler rooms and the transactions in question pre-date the adoption of the CFMA. As such, the CFMA cannot retroactively apply to Forex boiler rooms and their trading activities. These defenses appear to be solid. However, "no bright-line definition is determinative; the transactions must be viewed as a whole with a critical eye toward its underlying purpose."[294] Courts engage in this practical rationalization to prevent Forex boiler rooms from hiding behind the Treasury Department. Despite the courts' efforts, thousands of illegal Forex boiler rooms operating within a veneer of respectability have proliferated to the detriment of the unsuspecting public. Complicating matters, to date no court has found that the sale or purchase of swaps, futures or commodity options, violates the federal securities laws, or state securities laws because no private right of action exists under the CEA. Furthermore, courts are generally reluctant to award damages under circumstances regarding speculative investments such as swaps, options and the like.[295]

The decision in Zelener is inconsistent with the Supreme Court's ruling in Dunn. The facts in Zelener are worth briefly reviewing. The CFTC commenced an enforcement action against Michael Zelener and his company, British Capital Group, for defrauding 238 investors of approximately $4 million in Forex transactions.[296] Interestingly, the Seventh Circuit initially agreed with the CFTC that Michael Zelener and British Capital Group defrauded hundreds of investors. However, Michael Zelener successfully argued that the contracts in question were spot contracts with unique terms. As such, the contracts were not futures contract and were not within CFTC jurisdiction. The Seventh Circuit agreed with Michael Zelener and found that the contracts were not fungible[297] because each contract was unique in terms as to its amount, expiration, and delivery dates.[298]

The CFTC was, of course, concerned that national uniformity can only be achieved with a Supreme Court decision. This is precisely what occurred approximately ten years ago when the Second, Third, Seventh and Ninth Circuits disagreed as to the judicial interpretation regarding the Treasury Amendment, and the Supreme Court resolved such judicial non-uniformity in the Dunn decision. In Dunn, the Supreme Court gave the phrase "transactions in foreign currency" an ordinary and broad statutory meaning and refused to adopt the CFTC's narrower reading of the phrase.[299] The CFTC's narrow reading of the phrase "transactions in foreign currency" did not include options because options are made in contemplation of a "transaction in foreign currency" not in itself a transaction.[300] The Supreme Court disagreed. The Supreme Court held that given the Treasury Amendment's legislative history, it is natural to read the exemption as a complete exclusion of foreign currency transactions from the CFTC's regulatory scheme, except to the extent that transactions are conducted on a "board of trade."[301] Transactions that do not occur on a board of trade are illegal off-exchange transactions that CFTC may regulate.[302]

In Dunn, the Supreme Court was concerned about the impact that CFTC regulation would have on the Forex industry. The Supreme Court was "informed by amicus briefs that participants in the 'highly evolved, sophisticated'" OTC foreign currency markets include "commercial and investment banks, foreign exchange dealers, brokerage firms, corporations [and] money managers."[303] In the Supreme Court's view, the OTC market is a crucial element in international transactions and financial market participants need the flexibility to engage in transactions that will protect them from the volatility in foreign currency trading without unnecessary regulation.[304]

In Zelener, the Seventh Circuit raised a definitional issue regarding the appropriate application of the Treasury Amendment, and its successor, the CFMA. This time, the Seventh Circuit did not focus upon how one may distinguish a forward contract from a futures contract. Rather, the Seventh Circuit struck down the multi-factor-test utilized by the CFTC[305] as "too complicated."[306] The Seventh Circuit attempted to simplify the multi-factor test by making the status of a contract determinable at the time of contracting rather than looking to the performance of the parties under the contract. The court determined that only fungible contracts[307] are futures contracts and subject to CFTC jurisdiction. The Seventh Circuit noted that there is one exception: when the offeror of a spot contract guarantees the right of set off,[308] the spot contract becomes a futures contract and subject to CFTC authority.[309] The Seventh Circuit further reasoned that non-fungible contracts are not futures contracts because the terms are not standardized by the industry, but rather the "terms are unique to the transaction and not ordinarily capable of being exchanged with other contracts in a set-off."[310]

As such, the Seventh Circuit determined that the counterparties did not have the right to offset their position. That is, Michael Zelener did not promise his investors a subsequent contract to delay delivery under the terms of the original the contract. Therefore, the Seventh Circuit viewed the contracts as non-fungible without the right of set-off and outside of the scope of CFTC authority.[311] The court reasoned that since the contract in Zelener did not guarantee the right of set-off, the contracts were spot contracts and not futures contracts. The Seventh Circuit held that the CFTC had no authority to take enforcement action against a Forex boiler room that traded spot contracts because spot contracts were beyond the scope of CFTC jurisdiction.[312] Thus, the Seventh Circuit held in favor of Michael Zelener and British Capital Group, even though Michael Zelener and British Capital Group engaged in fraudulent trades that resulted in defrauding 238 unsophisticated small investors of approximately $4 million.[313]

The Seventh Circuit's analysis is incorrect. It is inconsistent with the New York's Southern District Court holding in CFTC v. Int'l Financial Service, which was rendered approximately one month prior to the Zelener decision. In CFTC v. Int'l Financial Services, the Southern District of New York held there is "no bright-line definition that is determinative" because no statute defines "futures contract." [314] Therefore, the entire Forex transaction must be viewed as a whole with a critical eye toward the underlying purpose[315] of the transaction between a Forex boiler room and unsophisticated small investors to determine whether fraudulent activity occurred. If unsophisticated small investors have been defrauded, the Treasury Amendment cannot be used to shield the Forex boiler room from prosecution. The CFTC must be allowed to assert jurisdiction. The Southern District of New York engaged in a practical rationalization of the Treasury Amendment and CFMA, recognizing that thousands of illegal Forex boiler rooms have proliferated to the detriment of the public and the need for the CFTC authority to protect the public could not be clearer.

[316] in part, to clarify the CFTC and SEC's enforcement authority against unregistered Type II Forex boiler rooms that offer Forex contracts to the public. The CFMA is a good example of Congress' attempt to protect the public from fraud in the Forex market.

[317]

Some commentators are concerned that CFTC regulation in the Forex market will result in unnecessary costly over-regulation, which will lead institutional and sophisticated investors to flee to unregulated offshore or foreign jurisdictions.[318] Perhaps having a gray area may be appropriate when dealing with consumer fraud problems, but it is not sound judgment when attempting to maintain stability within the Forex market.[319] The Treasury Amendment has experienced drastic changes in its current morphization as the CFMA. To a large extent, the new changes to the CFMA clarify some of the more ambiguous sections of the CEA and allow federal regulators greater latitude to protect the public.

Within the increasingly competitive international environment, domestic regulation over Type II Forex boiler rooms, although notable, may create substantial regulatory competition and increase institutional and sophisticated professional investors' costs. However, this should not deter legislative and private initiatives from finding a balance that will not stifle innovation for creating new financial products while simultaneously allowing for the maintenance of the Forex market's integrity, free of fraudulent Forex boiler room activity. The current variance in case law indicates that a fact-specific category of sophisticated professional investors are exempt from the CEA. It is uncertain whether a bright-line regulatory rule will be established. The need for a stable Forex market necessitates an unregulated yet, standardized Forex transactions.

Congress' recent approach provides the CFTC and SEC with enforcement authority against Type II Forex boiler rooms, but Forex boiler rooms have repeatedly challenged CFTC jurisdiction. The courts' varied interpretations of the Treasury Amendment provisions will certainly affect the legitimate Forex market. Unfortunately, the CFTC's increased regulatory authority may undoubtedly overflow into the broader Forex cash contract market. The challenge for Congress will be to revise the CEA yet again and provide specific meaning for financial market participants, while simultaneously allowing such specific meaning to evolve with time, as new and innovative financial instruments are created in the financial market industry.

As for Joanne, the defrauded unsophisticated small investor, who initially contacted the St. John's Securities Arbitration Clinic, the Clinic is pursuing her fraud claim against B&B Investments via the CFTC's reparation program.