[Federal Register Volume 63, Number 9 (Wednesday, January 14, 1998)]
[Proposed Rules]
[Pages 2188-2192]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-665]


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COMMODITY FUTURES TRADING COMMISSION

17 CFR Part 1


Maintenance of Minimum Financial Requirements by Futures 
Commission Merchants and Introducing Brokers

AGENCY: Commodity Futures Trading Commission.

ACTION: Proposed rules.

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SUMMARY: Rule 1.12 \1\ of the Commodity Futures Trading Commission 
(``Commission'' or ``CFTC'') sets forth the early warning reporting 
requirements for futures commission merchants (``FCMs'') and 
introducing brokers (``IBs''). These requirements are designed to 
afford the Commission and industry self-regulatory organizations 
(``SROs'') sufficient advance notice of a firm's financial or 
operational problems to take any protective or remedial action that may 
be needed to assure the safety of customer funds and the integrity of 
the marketplace. The Commission has determined to propose amendments to 
Rule 1.12, applicable to FCMs only, that will require immediate 
notification by an FCM to the Commission and its designated self-
regulatory organization (``DSRO'') if an FCM knows or should know that 
it is in an undersegregated or undersecured condition: i.e., the FCM 
has insufficient funds in accounts segregated for the benefit of 
customers trading on U.S. contract markets or has insufficient funds 
set aside for customers trading on non-U.S. markets to meet the FCM's 
obligations to its customers. The term ``funds'' in this context 
includes accrued amounts due to or from the FCM's clearing 
organizations and/or carrying brokers in connection with customer-
related activities, typically, the daily or intraday variation 
settlement.
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    \1\ Commission rules are found at 17 CFR Ch. I (1997).
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    The Commission is also proposing to require immediate notification 
of certain events pertaining to undercapitalization or failure to 
satisfy margin calls, where notice is currently required within 24 
hours. The Commission also proposes to codify a previous staff 
interpretation that permits notices to be filed by facsimile in 
addition to telegraphic means and to require immediate telephonic 
notice as well.

DATES: Comments mut be received on or before March 16, 1998.

ADDRESSES: Comments on the proposed amendments should be sent to Jean 
A. Webb, Secretary of the Commission, Commodity Futures Trading

[[Page 2189]]

Commission, 1155 21st Street, N.W., Washington, D.C. 20581. In 
addition, comments may be sent by facsimile transmission to facsimile 
number (202) 418-5221 or by electronic mail to [email protected]. 
Reference should be made to ``Early Warning Amendments''.

FOR FURTHER INFORMATION CONTACT: Paul H. Bjarnason, Jr., Deputy 
Director and Chief Accountant, Lawrence B. Patent, Associate Chief 
Counsel, Lawrence T. Eckert, Attorney-Advisor, or Charles T. O'Brien, 
Attorney-Advisor, Division of Trading and Markets, Commodity Futures 
Trading Commission, 1155 21st Street, N.W., Washington, D.C. 20581; 
Telephone (202) 418-5430.

SUPPLEMENTARY INFORMATION:

I. Background

    Rule 1.12 requires each FCM \2\ to report to the Commission and to 
the FCM's DSRO certain events pertaining to the FCM's: (i) Financial 
condition; and (ii) procedures for safeguarding customer and firm 
assets; and (iii) ability to monitor its financial condition through an 
appropriate system of records and reports. Rule 1.12's purpose is to 
notify the Commission and the FCM's DSRO of circumstances that have or 
could have a negative impact on the FCM's ability to carry on normal 
business operations or that pose a threat to customer funds or the 
FCM's financial integrity. Reportable events currently include, among 
others, the FCM's adjusted net capital's falling below its ``early 
warning'' level (i.e., 150 percent of the minimum required); \3\ 
failure to maintain current books and records; the existence of 
material inadequacies in the FCM's accounting systems or internal 
controls; and the issuance of a margin call exceeding the FCM's 
adjusted net capital. Collectively, these are known as the Commission's 
``early warning'' reporting requirements.
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    \2\ Certain portions of Rule 1.12 also apply to IBs. However, 
the proposed rule amendments discussed herein relate mostly to 
segregated funds and the secured amount, which involves FCM's but 
not IBs. Therefore, this release focuses upon Rule 1.12 as it 
pertains to FCMs.
    \3\ The minimum adjusted net capital requirement for an FCM is 
set forth in Rule 1.17(a)(1)(i) and basically requires an FCM to 
maintain adjusted net capital equal to the greatest of $250,000, 
four percent of the amount of customer funds or the amount required 
by an SRO of which the FCM is a member. Therefore, assuming no 
higher applicable SRO requirement, the early warning reporting is 
triggered if adjusted net capital is less than the greater of 
$375,000 or six percent of customer funds.
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    The ``segregation'' requirements of the Commodity Exchange Act 
(``Act'') and Commission rules are the primary safeguard against the 
loss of customer funds resulting from the financial failure of an FCM. 
Section 4d(2) of the Act \4\ and Rule 1.20 require that an FCM 
segregate customer funds from the firm's proprietary funds and that one 
customer's funds not be used to margin, guarantee or secure the trades 
or contracts, or to secure or extend the credit, of another 
customer.\5\ Other important elements of the segregation rules govern 
the investment of customer funds \6\ and require a daily record of 
segregation requirements and funds in segregation.\7\ Rule 30.7 
contains similar protections relating to customers maintaining 
positions on non-U.S. exchanges.\8\
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    \4\ 7 U.S.C. 6d(2).
    \5\ Rule 1.23 states that the prohibition against commingling an 
FCM's own funds with the FCM's customer funds does not prevent an 
FCM from adding any of its own funds to segregated customer funds as 
necessary to prevent any or all customer's accounts from becoming 
undermargined. The Commission recently adopted amendments to Rule 
1.23 that permit FCMs to use Treasury securities in addition to cash 
to increase their interests in customer segregated accounts, 
facilitating the use of FCM funds to prevent the undermargining of 
customer accounts. See 62 FR 42398 (Aug. 7, 1997).
    \6\ Section 4d(2) of the Act and Rules 1.25-1.29.
    \7\ Rule 1.32.
    \8\ A more detailed presentation concerning these protections 
can be found in Chapter 12 of the Form 1-FR-FCM instructions.
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    Given the importance of these rules in enabling the Commission to 
carry out its customer and market protection functions, it is critical 
that the Commission and an FCM's DSRO be made aware at the earliest 
possible moment of an FCM's failure to satisfy these requirements.\9\ 
The proposed CFTC rule would require an FCM to provide immediate 
telephonic notice, to be confirmed immediately by facsimile or 
telegram,\10\ to the Commission and the FCM's DISRO when the FCM knows 
or should know that it has failed to maintain sufficient funds in 
segregation or in separate set-aside accounts.\11\
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    \9\ The Commission notes that, in the Federal Register release 
proposing the Commission's overhaul of minimum financial 
requirements over twenty years ago, the Commission stated its 
intention to propose an early warning notice for undersegregation of 
customer funds. See 42 FR 27166, 27173 (May 26, 1997). However, the 
Commission did not subsequently include such a rule as part of its 
early warning requirements.
    \10\ Telegraphic notification has been the traditional method of 
required notice under Rule 1.12, whereby an FCM or an IB sends a 
telegram to the Commission and the DSRO concerning a particular 
event.
    \11\ The Chicago Mercantile Exchange (``CME'') currently has a 
rule requiring that FCMs for which it acts as the DSRO provide 
written notice to it in such circumstances, although the CME's rule 
requires such notification within twenty-four hours following such 
events. Rules of the Chicago Mercantile Exchange, Rule 971 
Segregation and Secured Requirements (1997).
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II. Proposed Rule Amendments

    FCMs occasionally have become undersegregated as a result of market 
movements which cause deficits in the accounts they carry on behalf of 
their customers. Generally, the undersegregated condition is corrected 
the following business day with funds available from an FCM's own 
proprietary funds or through collection of deficits. However, during 
the market downturn on October 27, 1997, the Commission was made aware 
that a few FCMs experienced undersegregation to a degree that they were 
unable to make up the shortfall from their own internal proprietary 
funds. Infusions of external capital were required in those cases to 
correct the undersegregated conditions.
    An evaluation of the Commission's current early warning 
notification rules indicated that these rules, which require notice to 
the Commission upon an FCM falling below the net capital early warning 
level, may not result in notice to the Commission until as much as a 
day or a day and a half after the occurrence of a major market event 
which causes an undersegregated condition. In particular, on October 
27, some firms knew they had a major problem by noon of that day, but 
did not provide notice of these problems to the Commission until on or 
about the close of business on October 28.
    The Commission believes that it needs to be notified as soon as an 
FCM knows that it may have a problem meeting segregation requirements. 
The proposed rule is designed to require notice as soon as an FCM 
``should know'' of an undersegregated condition. Because of the linkage 
between segregation and net capital, the proposed rule will also result 
in the Commission knowing of a net capital impairment earlier than 
under the existing rule and should facilitate a resolution of the 
problem with the least harmful impact upon an FCM's customers and other 
market participants.
    As proposed, new Rule 1.12(h) \12\ would require an FCM to notify 
the Commission and its DSRO immediately after it knows or should know 
that funds segregated for customers trading on U.S. markets or set 
aside for customers trading on non-U.S. markets are less than the 
amount required to be segregated or set aside by the Act or Commission 
rules. In this context, the term ``funds'' includes funds on deposit 
and funds due to or from the FCM's clearing organizations or carrying

[[Page 2190]]

brokers. The Commission's proposal requires an immediate telephone call 
by an FCM, to be followed immediately by telegraphic or facsimile 
notice.\13\ The notification to the Commission should be directed to 
the Division of Trading and Markets, to the attention of the Director 
and the Chief Accountant. Notice to the DSRO should be directed to the 
person or unit provided for under the DSRO's rules. For example, the 
notice required by CME Rule 971 must be sent to CME's Audit Department.
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    \12\ The Commission is proposing to redesignate current 
paragraph (h) of Rule 1.12 as paragraph (i) and to include the new 
rule in a new paragraph (h).
    \13\ The Division of Trading and Markets has stated that any 
notice required to be transmitted to the Commission under Rule 1.12 
by telegraphic notice may be transmitted by facsimile machine. See 
CFTC Advisory No. 90-2, [1990-92 Transfer Binder] Comm. Fut. L. Rep. 
(CCH) para. 24,599 (Feb. 6, 1990). The Commission is proposing to 
codify this Advisory throughout Rule 1.12 to make clear that any 
written notice can be provided either through telegraphic means or 
via facsimile transmission.
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    In accordance with Rules 1.32 and 30.7(f), each FCM is required to 
complete its daily segregation and secured amount computations by noon 
of the business day following the day for which the computations are 
made.\14\ The time when the Commission would expect an FCM to be aware 
of an undersegregated condition or a possible undersegregated condition 
would depend upon the circumstances. In this connection, both the net 
capital rule and the segregation rules require compliance at all times. 
Intra-day changes in the prices of contracts carried by an FCM may 
require settlement variation payments. As of the close of trading each 
day, there is an accrued settlement amount which is payable to or 
receivable from the FCM's clearing organization. A receivable from a 
clearing organization is reflected as an asset on the FCM's segregation 
calculation, and conversely, a payable to a clearing organization is a 
liability. It is important to note that, in the event of a major move 
in the market, these amounts could be substantial and, if the move is 
against the FCM's customers, it could result in an undersegregated 
condition due to a deficit or deficits in the accounts of one or more 
customers.
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    \14\ Rule 1.32 states that each FCM must compute as of the close 
of each business day the total amount of customer funds on deposit 
in segregated accounts on behalf of commodity and option customers 
and the total amount of such funds required by the Act and 
regulations to be on deposit in segregated accounts on behalf of 
such customers, as well as the FCM's residual interest in such 
funds. Rule 30.7(f) states that each FCM must compute as of the 
close of each business day the total amount of money, securities and 
property on deposit in separate accounts, the total amount of money, 
securities and property required to be on deposit in separate 
accounts and the amount of the FCM's residual interest in money, 
securities and property on deposit in separate accounts.
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    In the event of a major market move, the Commission would expect an 
FCM to consider the impact of that move on the values of the positions 
it is carrying and how this impact would affect the accrued payable to 
its clearing organizations and the deficits in customer accounts. If 
the FCM has reason to believe that this impact could be material and 
negative in relation to previously computed excess segregation, it 
would be advisable to report a possible undersegregated condition to 
the Commission.
    However, in some cases losses may occur over a large number of 
accounts in smaller amounts that, cumulatively, may cause an FCM to 
become undersegregated. In such a circumstance, the Commission 
recognizes that an FCM may not become aware of an undersegregated 
condition until it performs its daily segregation computation the 
following day. In any event, an FCM would be expected to notify the 
Commission of a deficiency in its segregated accounts by noon of the 
following business day.
    Proposed new Rule 1.12(h), like the other provisions of the early 
warning system, is intended to allow protective action to be taken. The 
Commission wishes to emphasize that the triggering event is when an FCM 
knows or should know that the FCM has a deficiency, as discussed above. 
An FCM should not attempt to circumvent the rule simply by delaying 
making the computations until noon of the next business day when it is 
clear from market events or other factors that a deficiency likely 
exists.
    The Commission also wishes to note that, while Rule 1.12(h) would 
require only that an FCM notify the Commission and its DSRO of a 
segregation or secured amount deficiency immediately, a firm with a 
notification obligation under Rule 1.12(h) may incur additional 
requirements under other early warning rules or Commission regulations. 
For example, a firm that is undersegregated may also be 
undercapitalized and thus be required (in addition to notifying the 
Commission) to comply with various filing requirements under Rule 
1.12(a)(2).\15\ Although the Commission is not proposing any specific 
further reporting by an FCM that files notice of a segregation or 
secured amount deficiency, under Rule 1.10(b)(4) the Commission may 
request in writing that an FCM also file a Form 1-FR-FCM or provide 
such other additional financial information as the Commission may 
require. This could include, for example, a request that the FCM file 
daily segregation or secured account computations with the Commission 
for a specified period, rather than simply making such records 
available for inspection.\16\
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    \15\ Rule 1.12(a)(2) requires that an FCM whose adjusted net 
capital is below the amount required under Rule 1.17 or under the 
capital rule of any applicable SRO, within twenty-four hours of 
giving notice of such occurrence to the Commission, file for the 
period ``as of'' the date of the adjusted net capital deficiency, a 
statement of financial condition, a statement of the computation of 
the minimum capital requirements, the statements of segregation 
requirements and funds in segregation, and the statement of secured 
amounts and funds held in separate accounts for foreign futures and 
foreign options customers.
    \16\ Rule 1.31 requires that all records required by the Act or 
Commission rules be maintained for five years under specified 
conditions and be available for inspection by any representative of 
the Commission or the United States Department of Justice.
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    Although the Commission's early warning rules already require an 
FCM to notify the Commission if the FCM is undercapitalized, large 
market moves such as those which occurred on October 19, 1987, and more 
recently on October 27, 1997, can cause a firm to be undersegregated 
even though it is not undercapitalized. A large market move can create 
unsecured ``debit/deficit'' accounts, which present greater risk for an 
FCM than undermargined accounts since the customer now owes the FCM 
money. Accounts of this kind would generally be subject to a margin 
call. In that case, absent the FCM being aware of doubts regarding its 
customer's ability to pay the deficit or debit, the FCM carrying the 
account has one business day from the date on which the deficit or 
debit ledger balance originated before it must reclassify the account 
as a ``non-current asset'' in computing its adjusted net capital.\17\ 
Likewise, the FCM must put sufficient funds from its own capital into 
the segregated account to cover the deficit amount or debit ledger 
balance, thus ensuring that there are sufficient segregated funds to 
cover all customers with liquidating equities in their accounts. Should 
the FCM not have sufficient funds to cover the debit or deficit amount, 
the FCM would be undersegregated, although not necessarily 
undercapitalized. The proposed rule is intended to require that notice 
to the CFTC and the DSRO be provided immediately in such 
circumstances.\18\
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    \17\ Rule 1.17(c)(2) (i) and (vi).
    \18\ The Commission also proposes to correct the cross-reference 
in Sec. 1.12(g)(2) concerning consolidation that now refers to 
`'Sec. 1.10(f)'' to read ``Sec. 1.17(f)''.
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    The Commission believes that notice that an FCM is undersegregated 
or undersecured should be provided immediately. In reviewing other 
provisions of the early warning requirements, the Commission has

[[Page 2191]]

determined to propose that notices of events now required within 24 
hours, which must be provided when an FCM or IB is undercapitalized or 
when an account must be liquidated, transferred or allowed to trade for 
liquidation only, now be provided immediately. Such notifications would 
be required by telephone immediately, to be confirmed in writing by 
telegraph or facsimile. See Rule 1.12 (a)(1), (f)(1), and (f)(2).\19\
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    \19\ Certain other provisions of Rule 1.12 currently require 
immediate notifications. See paragraphs (e), (f)(3), (f)(4) and 
(f)(5) of Rule 1.12. The Commission is also proposing that these 
notifications be made by telephone as well as by telegraph or 
facsimile.
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III. Related Matters

A. Regulatory Flexibility Act

    Regulatory Flexibility Act (``RFA''), 5 U.S.C. 601-611 (1994), 
requires that agencies, in proposing rules, consider the impact of 
those rules on small businesses. The rule amendments discussed herein 
would affect primarily FCMs. The amendment of one provision, 
Sec. 1.12(f)(1), would affect clearing organizations, and the amendment 
of another provision, Sec. 1.12(a)(1), would affect IBs. The Commission 
has previously determined that, based upon the fiduciary nature of the 
FCM/customer relationships, as well as the requirement that FCMs meet 
minimum financial requirements, FCMs should be excluded from the 
definition of small entity.\20\ Contract markets and their clearing 
organizations have also been excluded from the definition of small 
entity.\21\
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    \20\ 47 FR 18618-18621 (April 30, 1982).
    \21\ Id.
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    The proposed amendment to Sec. 1.12(a)(1) concerning notice of 
undercapitalization would affect the minority of IBs that rely upon 
their own capital to meet net capital rules, ``independent'' IBs, as 
well as FCMs. The Commission is proposing to require that this notice 
be provided immediately rather than within 24 hours as currently 
required. The notification requirement will remain essential the same, 
but the timing would be shortened by 24 hours. The Commission believes 
that this rule amendment is necessary for the Commission and DSROs to 
be able to carry our their overishgt and monitoring functions 
concerning the financial condition of futures industry intermediaries 
and to protect the customers of those firms and the markets. Therefore, 
any slight increase in the burden on an independent IB caused by the 
proposed amendment to Rule 1.12(a)(1) is necessary for the Commission 
to fulfill its regulatory obligation.\22\
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    \22\ The Commission evaluates within the context of a particular 
rule proposal whether all or some IBs should be considered small 
entities and, if so, analyzes the impact on IBs of the proposal 48 
FR 35248, 35276 (Aug. 3, 1983).
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    Accordingly, on behalf of the Commission, the Chairperson certifies 
that these proposed rule amendments will not have a significant 
economic impact on a substantial number of small entities.

B. Paperwork Reduction Act

    The Paperwork Reduction Act of 1980 (``PRA''), 44 U.S.C. 3501 et 
seq. (1994), imposes certain requirement on federal agencies (including 
the Commission) in connection with their conducting or sponsoring any 
collection of information as defined by the PRA. The Commission 
anticipates that fewer than 10 FCMs per year would be filing reports 
under the proposed rule and thus the new rule would not constitute a 
collection of information under the PRA.\23\ The group of rules (3038-
0024) of which this is a part has the following burden:
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    \23\ 44 U.S.C. 3502(4) 1994)
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    Average Burden Hours Per Response: 128.
    Number of Respondents: 1366.
    Frequency of Response: On occasion.
    Persons wishing to comment on the estimated paperwork burden 
associated with this proposed rule amendment should contact Jeff Hill, 
Office of Management and Budget, Room 3228, NEOB Washington, DC 20503, 
(202) 395-7340. Copies of the information collection submission to OMB 
are available from the CFTC Clearance Officer, 1155 21st Street N.W., 
Washington, DC 20581, (202) 418.5160.

List of Subjects in 17 CFR Part 1

    Commodity futures; minimum financial and relating reporting 
require.

    In consideration of the foregoing, and pursuant to the authority 
contained in the Commodity Exchange Act, and in particular, Sections 
4f, fg and 8a(5) therof, 7 U.S.C. 6f, 6g and 12a(5), the Commission 
hereby proposes to amend Part 1 of chapter I of title 17 of the Code of 
Federal Regulations as follows:

PART 1--GENERAL REGULATIONS UNDER THE COMMODITY EXCHANGE ACT

    1. The authority citation for Part 1 continues to read as follows:

    Authority: 7 U.S.C. 1a, 2, 2a, 4, 4a, 6, 6a, 6b, 6c, 6d, 6e, 6f, 
6g, 6h, 6i, 6j, 6k, 6l, 6m, 6n, 6o, 6p, 7, 7a, 7b, 8, 9, 12, 12a, 
12c, 13a, 13a-1, 16, 16a, 19, 21, 23 and 24.
    2. Section 1.12 is amended by revising paragraph (a)(1), by 
revising the first sentence of paragraph (b)(4), by adding the phrase 
``or facsimile'' after the word ``telegraphic'' in paragraphs (c) and 
(d), by revising paragraph (e), by adding the phrase ``telephonic, 
confirmed in writing by'' before the word ``telegraphic,'' by adding 
the phrase ``or facsimile,'' after the word ``telegraphic,'' and by 
revising the phrase at the end which reads ``within 24 hours'' to read 
``immediately'' in paragraphs (f)(1) and (f)(2), by adding the phrase 
``telephonic, confirmed in writing by'' before the word ``telegraphic'' 
and by adding the phrase ``or facsimile,'' after the word 
``telegraphic'' in paragraph (f)(3), by adding the phrase ``by 
telephone, confirmed in writing immediately by telegraphic or facsimile 
notice,'' after the word ``immediately'' in paragraphs (f)(4) and 
(f)(5), by revising the phrase in paragraph (g)(2) which reads 
``Sec. 1.10(f)'' to read ``Sec. 1.17(f)'', by redesignating paragraphs 
(h)(1) and (h)(2) as paragraphs (i)(1) and (i)(2), respectively, by 
revising the last sentence of newly redesignated paragraph (i)(2), and 
by adding a new paragraph (h). The additions and revisions follow:


Sec. 1.12  Maintenance of minimum financial requirements by futures 
commission merchants and introducing brokers.

* * * * *
    (a) * * *
    (1) Give telephonic notice, to be confirmed in writing by 
telegraphic or facsimile notice, as set forth in paragraph (i) of this 
section that the applicant's or registrant's adjusted net capital is 
less than required by Sec. 1.17 or by other capital rule, identifying 
the applicable capital rule. This notice must be given immediately 
after the applicant or registrant knows or should know that its 
adjusted net capital is less than is required by any of the aforesaid 
rules to which the applicant or registrant is subject; and
* * * * *
    (b) * * *
    (4) For securities brokers or dealers, the amount of net capital 
specified in Rule 17a-11(b) of the Securities and Exchange Commission 
(17 CFR 240.17a-11(b)), must file written notice to that effect as set 
forth in paragraph (i) of this section within five (5) business days of 
such event. * * *
* * * * *
    (e) Whenever any self-regulatory organization learns that a member 
registrant has failed to file a notice or written report as required by 
this Sec. 1.12, that self-regulatory organization must immediately 
report this failure by

[[Page 2192]]

telephone, confirmed in writing immediately by telegraphic or facsimile 
notice, as provided in paragraph (i) of this section.
* * * * *
    (h) Whenever a person registered as a futures commission merchant 
knows or should know that the total amount of its funds on deposit in 
segregated accounts on behalf of customers, or that the total amount 
set aside on behalf of customers trading on non-United States markets, 
is less than the total amount of such funds required by the Act and the 
Commission's rules to be on deposit in segregated or secured amount 
accounts on behalf of such customers, the registrant must report 
immediately by telephone, confirmed in writing immediately by 
telegraphic or facsimile notice, such deficiency to the registrant's 
designated self-regulatory organization and the principal office of the 
Commission in Washington, DC, to the attention of the Director and the 
Chief Accountant of the Division of Trading and Markets.
    (i) * * *
    (2) * * * Any notice or report filed with the National Futures 
Association pursuant to this paragraph shall be deemed for all purposes 
to be filed with, and to be the official record of, the Commission.

    Issued in Washington, D.C. on January 6, 1998 by the Commission.
Jean A. Webb,
Secretary of the Commission.
[FR Doc. 98-665 Filed 1-13-98; 8:45 am]
BILLING CODE 6351-01-P