When three commodity brokers went bankrupt late last year, hundreds of their customers fell straight through the safety nets that protect most investors.
There's no government insurance program like the Federal Deposit Insurance Corp. or the Securities Investor Protection Corp. to bail out commodity investors whose brokers go broke.
The only watchdog guarding their interests is the Commodity Futures Trading Commission, which has neither the manpower nor the mandate to audit every broker's books.
Nor could the customers count on the commodity industry to protect them in the way the New York Stock Exchange and National Association of Securities Dealers monitor their members because the three bankrupt brokers didn't belong to any commodity exchange.
As a result the customers wound up in bankruptcy court and the commodity industry had a $7 million scandal on its hands.
To prevent the all-too-regular recurrence of such troubles among independent commodity brokers, the industry is moving to establish a federally chartered self-regulatory agency with power to police the burgeoning trade in futures contracts.
The plan to set up a National Futures Association closely comparable to the National Association of Securities Dealers and make membership mandatory for virtually everyone in the retail commodity business went to the CFTC a few days ago.
Through meant to be an alternative to further federal regulation, the commodity industry's self-policing plan could turn out to be a test of the Reagan administration's regulatory philosophy.
The Reaganauts generally prefer private rather than government control over the marketplace. But the self-regulation proposed by the commodity trade so closely mimics government action that it bothers the more conservative Reagan regulators.
The hang-up is the mandatory-membership proposal, which also was attacked by President Carter's Justice Department trust-busters. When the NFA idea first was proposed almost five years ago, the Antitrust Division objected that a mandatory-membership organization could tend to reduce competition. Congress specifically exempted the NFA from antitrust laws two years ago.
In a report to the CFTC, the Public Interest Economic Center said the self-regulatory agency is "not only anticompetitive but also would place the self-regulatory responsibility for market efficiency and customer protection in the same hands that hold them now with no added controls."
James Miller, chairman of the Reagan administration's regulatory task force, also has expressed reservations about giving what amounts to government regulatory authority to a private organization.
If everyone in the industry isn't required to join the self-regulatory group, "Such an organization would be worthless," argues Leo Malamed, a Chicago Mercantile Exchange official and one of the handful of fathers of the National Futures Association.
Another of the industry officials behind the NFA is Phillip Johnson, the Chicago commodity lawyer recently chosen by the Reagan administration to be the new chairman of the CFTC. Johnson, who has been counsel to the NFA, apparently will have to remove himself from the CFTC's deliberations over whether to charter the self-policing group.
The principal target of the new organization is the growing number of commodity brokers who are not members of any of the nation's dozen commodity exchanges. Any broker who buys a seat on an exchange is automatically subject to the exchange's rules of conduct and its minimum financial requirements. But many small stock and commodity brokers don't join the exchange; they take orders from the public and funnel them to an exchange member for execution.
Four years ago there were 59 nonmenber commodity brokers. As of Jan. 1 there were 114 of them, said John Manley, director of trading and markets for the CFTC. The nonmembers are generally weaker firms and less experienced and account for an inordinate share of the industry's troubles, Manely explained. "Every time a customer loses money through no fault of their own, other customers are driven away from the commodity industry," he added.
"The nonexchange members have given the industry a black eye," agreed David T. Johnson, head of the commodity department at E. F. Hutton and another of the long-time advocates of a National Futures Association.
"This is the opportunity for the industry to demonstrate it can regulate itself," added Johnston. "It should reduce the number of bankruptcies of nonmembers" by assuring that "everybody operates under the same rules."
The NFA will regulate only the commodity industry's dealings with the public, not the internal operation of the business, Johnston stressed. The organization will police misconduct, including fraud, deception and cheating of customers, misuse of customers' money, manipulation of the market, unjust or inequitable treatment of customers and false reports to customers on the performance of commodity accounts.
As proposed, the NFA would have the power to fine, suspend or, expel commodity dealers, much as the NASD disciplines stockbrokers.
The authority to create a self-regulatory commodity group was born in 1975 as part of the legislation that created the CFTC. Intraindustry wrangling has kept the idea from blossoming until now. Some members of commodity exchanges objected to imposition of another layer of regulation.The small commodity exchanges in New York, Kansas City and Minneapolis feared any industry organization would be dominated by the Chicago Mercantile Exchange and the Chicago Board of Trade, which already have the lion's share of the business.
The later issue was approached by creating an unusually large 42-member board of directors with seats reserved for various constituents. The smaller exchanges still aren't convinced Chicago won't run the show, but they're going along with the plan.
The extra-layer-of-regulation question has taken a lot of hard selling by Johnston, Malamed and other backers of the plan. "Self-regulation at additional cost is better than forced regulation by an agency of the federal government," insists Malamed.
To pay the estimated $6 million to $10 million cost of the NFA, the group has asked the the CFTC for authority to impose a 40-cent fee on every commodity futures contract traded.