A landmark court decision challenges critical elements of current futures regulation and could open the door for single-stock futures.

By Robert Hunter

When the Chicago Board of Trade began trading futures on the Dow Jones Industrial Average in 1997, it made it clear to everyone listening that once the DJIA products took off, futures on other Dow Jones indices would follow.

Last year, the CBOT tried to implement that strategy by petitioning regulators to list futures on the Dow Jones Utilities and Transportation Indices. Under the 1982 Shad-Johnson Accord, futures exchanges wishing to list stock index futures must first get a green light from the Securities and Exchange Commission before petitioning the Commodity Futures Trading Commission for ultimate approval.

The CBOT’s plans were quickly derailed when the SEC rejected the products, arguing, among other things, that the indices involved were too narrow and thus were prone to manipulation, which could add volatility to the underlying market. This has been the SEC’s tireless refrain whenever asked to comment about possible amendments to the Shad-Johnson Accord or the Commodity Exchange Act itself.

Rather than taking the decision as a defeat and going back to the drawing board, the CBOT decided to fight back. It appealed the decision to the Seventh Circuit Court of Appeals, located conveniently in Chicago. And last month came some truly shocking news: The court reversed the SEC’s rejection of the CBOT’s request, and, in an unusually punitive move, declined to remand the proposal to the SEC for further review. The court sent the matter directly to the CFTC for final approval. “If, within the statutory time, the SEC has not given a satisfactory reason for rejecting a proposed futures contract,” the court opinion scolded, “it does not get a second chance.”

The reversal is viewed as a major victory for the CBOT, of course, but its long-term ramifications could be monumental for the industry as a whole. It represents the first reversal of an SEC rejection of a futures contract proposal, and it comes at a time when futures exchanges are lobbying hard to chip away at some of the more restrictive elements of futures regulation. The CBOT and the Chicago Mercantile Exchange joined forces in May to propose in Congressional testimony a radical new regulatory regime for futures, including the elimination of the contract approval process and the removal of some of the product restrictions in the Shad-Johnson Accord. Their biggest target: Shad-Johnson’s restriction of narrow-stock-index and single-stock futures. Their proposal has many supporters in Congress, and will receive a great deal of attention during the next Congressional reauthorization of the CFTC, set for next year.

While the Seventh Circuit Court’s 3–0 decision doesn’t explicitly embrace single stock futures, it represents the first weakening of the Shad-Johnson restrictions. “The stock exchanges prefer less competition,” the court found, “but if competition breaks out, they prefer to trade the instruments themselves.” The court took aim at the virtual veto power the SEC enjoys under Shad-Johnson as well, writing that “Congress has entrusted the CFTC with the task of regulating futures markets, and the SEC is not entitled to adopt a ‘my way or the highway’ view by using its approval power…as a lever.”

The court also ridiculed the SEC’s argument that the Dow Jones indices were prone to manipulation because of their narrowness. “If someone were determined to drive the price of transportation stocks up or down, buying and selling thousands of futures contracts on the Chicago Board of Trade would be like pouring a Dixie cup of water into Lake Michigan: there would be an effect, but it would not be detectable.”

In a concurring opinion, Judge Richard Cudahy echoed this sentiment. “There is something remarkable about finding inadequate the most venerable stock index of them all—originally the Dow Jones Railroad Average—launched in 1896 and still widely in circulation,” he wrote. “Almost prima facie, the rejection of this index renders the SEC view suspect.”

Predictably, the CBOT was thrilled with the ruling. “This decision is a victory of fairness over bureaucracy,” said CBOT president and CEO Thomas Donovan, “and it is a clear message from the court that SEC limitations on stock-index futures are unfair and illegal. It is time to take the handcuffs off U.S. exchanges. We look forward to working with Congress and the new leadership at the CFTC in pursuit of broad regulatory reform that includes elimination of outmoded Shad-Johnson restrictions.”

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