By Benjamin Cox
The regulatory authority of the U.S. Commodity Futures Trading Commission (“CFTC”) covers “options” which are adroitly defined as “transaction(s) . . . held out to be of the character of, or . . . commonly known to the trade as . . . ‘option(s)’. . . .” 7 U.S.C. § 1a(36) (2012). But what is the essential “character of” an option contract? Our condolences to District Court Judge Miranda Du, who must decide this question, which seems more appropriate for a Platonic dialogue than a court opinion.
As we reported last June, the binary option trading platform Banc de Binary currently faces a civil lawsuit in the District of Nevada brought by the CFTC for allegedly violating “the Commission’s ban on trading options off-exchange.” See Complaint, CFTC v. Banc de Binary, No. 2:13-cv-00992 (D. Nev. filed June 5, 2013) (Dkt. No. 1).
According to the CFTC, Banc de Binary allows customers to open and fund accounts through their website and then “execute trades by selecting a particular asset on the website and predicting if that asset’s current price will go up or down on a date and time certain.” Banc de Binary moved to dismiss Counts I and IV of the CFTC Complaint, plausibly arguing that, notwithstanding their “colloquial” designation as “options,” binary options are not really options at all. Motion to Dismiss, CFTC v. Banc de Binary (Dkt. No. 18). The motion has been fully briefed, but Judge Du has yet to render a decision.
Binary options are a relatively new concept — you won’t find an entry for them in Black’s Law Dictionary. A traditional option contract has at least three essential components: (i) it is a method of speculating in the rise or fall of the market price of commodities or stocks; (ii) it gives the option holder the right to purchase that commodity or stock in the future at a predetermined value; and (iii) the right to exercise the option is, indeed, optional.
In opposition to Banc de Binary’s motion to dismiss, the CFTC argues that what makes an option an option is the first of these three components—price speculation. Opposition, CFTC v. Banc de Binary, (Dkt. No. 37). Thus, the CFTC contends that binary options are options because buyers “predict (‘up’ or ‘down’) whether a price will rise above the current level, choose the investment amount that he or she wishes to trade, decide the expiration time of his or her choice, pay a premium, [and] select a strike price. . . .” Id. at 19.
Banc de Binary concedes, as it must, that its binary options are a means to speculate in the future prices of certain commodities and stocks, but argues that the essential character of an option is the second of these components — the right to purchase the underlying commodity or stock. In a parallel lawsuit brought by the Securities and Exchange Commission, Judge Robert Jones (District of Nevada) agreed, explaining:
With a binary option, . . . the purchaser receives neither the stock itself nor the right to purchase the stock in the future. Binary options are in substance pure gambling bets. . . . Binary option givers and buyers do not purport to trade interests in securities any more than tellers and gamblers at a racetrack purport to trade interests in horses. . . . The Court simply cannot agree that a contract under which the purchaser has no putative right to obtain the security is an “option.”
Order, SEC v. Banc de Binary, No. 2:13-cv-00993, at 5-8 (D. Nev. Aug. 7, 2013) (Dkt. No. 31). Judge Jones also found that the third essential component of an option—its optional nature—also distinguished binary options from their mainstream counterparts, because binary options always exercise automatically:
An ‘option’ is the right, but not the duty, to do something, i.e., the possibility of exercising the right to a particular course of action. Binary options simply do not contain this characteristic. They do not even give the purchaser the right to determine whether or when to execute the supposed “option.” They give the purchaser no putative right to choose any future course of action whatsoever.
Id. at 9. Perhaps wisely, Banc de Binary did not press this distinction in the CFTC case, because while it is true that traditional options do not exercise automatically, they are exercised very predictably (it is generally irrational to exercise an option that is priced higher than the stock price). Ultimately, Judge Jones determined that binary options could still be regulated by the SEC because, although they are not true options, they are covered by other statutory language allowing for SEC regulation of “privileges . . . based on the value [of securities]. . . .” Id. at 10 (quoting 15 U.S.C. § 78(a)(10)).
Recently, the Dodd-Frank Act expanded the CFTC’s regulatory authority so that it also covered a “swap,” which is defined as “an agreement, contract, or transaction . . . that is a[n] . . . option of any kind that is for the purchase or sale, or based on the value, of 1 or more . . . financial or economic interests of any kind. . . .” 7 U.S.C. § 1a(47)(A)(i) (italics added). Banc de Binary conceded that this new language applied to their binary options and did not move to dismiss Count II of the CFTC complaint.
Indeed, binary options do appear to be “based on the value” of commodities or stocks because they exercise based on the rise or fall in the asset value, even if they are not priced and do not pay out in a way that corresponds with the actual value of the underlying asset. CFTC regulation over swaps became effective on October 12, 2012. Still, if Banc de Binary is right that binary options are subject to CFTC regulation as swaps but not options, then they may escape liability for U.S. activity before October 12, 2012.
Banc de Binary also moved to dismiss Count III, which alleged that its bonus program (whereby new deposits into a customer’s account would be matched) illegally offered leveraged, margined, or financed transactions. According to Banc de Binary, binary options purchased with bonus funds were not leveraged, margined, or financed, because in no event would the customer “be liable for losses in an amount that exceeded his or her deposit.” Motion to Dismiss at 11.
According to a recent Scheduling Order and Joint Status Report, motions for summary judgment are due in two months and are likely to resolve disputes that remain after Banc de Binary’s Motion to Dismiss is decided.