Energy Derivatives: Which Country (U.S. or U.K. Provides the Best Customer Asset Protections to an Energy Trading Firm If Its Brokerage Firm/counterparty Files for Bankruptcy?
Over the past eight years or so, we have seen some very large brokerage firms file for bankruptcy. They include Lehman Brothers in September 2008 and MF Global in October 2011.1 Other firms, such as Bear Stearns and AIG Insurance Company, would have filed for bankruptcy but for some intervening events.2 Other financial firms came close to filing. These financial firms are located around the globe, but the two major financial centers are New York and London. Exchanges that offer energy products are located in both cities. The world's largest banks and brokerage firms have their headquarters or large principal offices in both of these cities. Since the 2008 financial crisis, there have also been major legislative and regulatory changes on a global basis, affecting the trading of derivatives and financial institutions engaged in such trading. What has not changed are the global bankruptcy laws that apply in the event the financial firm fails. This article will address the different legal and regulatory landscapes in both the United States and the United Kingdom that protect the assets of energy trading firms that are held directly by financial firms in these two countries and what happens to such assets when the respective financial firm files for bankruptcy. It shall also address legislative and regulatory changes still needed and best practices energy trading firms should consider when doing business with U.S. and U.K. financial firms.I. INTRODUCTIONI teach several courses at New York Law School including, among others, Securities Regulation, Derivatives Market Regulation, and Regulation of Broker Dealers and Futures Commission Merchants. In each course, there are one or more classes on the bankruptcy of financial firms and how customer assets held by the financial firms are or are not protected in such bankruptcies. As I start to discuss these customer asset protection issues, I always ask my students the following question: "In your checking account, albeit probably one with a small amount, do you care what the bank does with your funds?" Of course, they all respond "Yes," but then I explain how the Federal Deposit Insurance Corporation (FDIC) protects banking customers by providing a government backed insurance program that pays up to $250,000 if the underlying bank fails.3 The students then feel somewhat better for some reason, but they still believe the bank should not be allowed to do whatever it wants with their deposits. I then explain how the Securities Investor Protection Corporation (SIPC) another government sponsored insurance program, protects customers of a broker dealer (BD) (e.g. a stock brokerage firm) by paying up to $500,000 if the BD fails.4 Most law students are not as interested as only a few have ever opened a stock brokerage account. Then, I discuss how futures and derivatives customers of a U.S. Futures Commission Merchant (FCM) have no such government sponsored insurance program to protect them in the unlikely event the FCM files for bankruptcy.5 They then have a puzzled look on their faces, as if they were silently asking "why not?" The absence of a government sponsored insurance program for derivatives thus requires energy firms that trade derivatives to focus on the applicable laws and regulations that apply regarding how their assets, which are held at a financial firm, are protected in the event the financial firm fails.This article will discuss the various laws and regulations, here in the United States and in the United Kingdom, if a U.S. or a U.K. futures and OTC derivatives financial firm files for bankruptcy and how customer assets are protected in each country. These customer asset laws and regulations refer to a concept of customer segregation in the United States and client money rules in the United Kingdom. While similar in nature, there are some major differences between the U.S. and U.K. customer asset protection regimes. These differences require energy trading firms to consider where to do their futures and OTC derivatives trading activities.