Is There A State Role For Binary Option Regulation?

The North American State Securities Administrators Association (NASAA) recently warned investors about the risks of investing in binary options.  While NASAA asserts that many binary trading platforms are "unregulated or are completely illegal", I found it surprising that it didn't cite any state securities or other laws that might regulate, much less outlaw, binary options or binary option trading platforms (other than financial professional licensing).  The Commodity Futures Trading Commission’s (CFTC) Office of Consumer Outreach and the Securities & Exchange Commission’s (SEC) Office of Investor Education and Advocacy have also issued a joint advisory warning about fraudulent binary option schemes.  The CFTC/SEC advisory notes that some of these "schemes" are operated fraudulently while others may fail to comply with applicable federal registration and regulatory requirements.  Like NASAA's advisory, the federal advisory does not mention the possible application of state law.

First, what is a binary option?  NASAA describes it as "a simplified options contract that looks more like online gambling than a traditional security or investment".  Essentially, the investor is promised a return if the price of a security goes up and loses everything if it doesn't:

For example, an investor enters into a binary option contract worth $100 that promises to pay the investor a 95% return if Company ABC’s stock rises from its current trading price of $20 per share to $25 per share by a certain date. If it does, the payout is 195% of the contract’s original value, or a total of $195 ($100 + $95). If it doesn’t, the payout is $0 – a complete loss of the original investment.

NASAA, Informed Investor Advisory (November 2015).

Binary options may also run afoul of state bucket shop laws, a subject covered in yesterday's post.  One problem, however, might be federal preemption of those state laws.  Section 28(a) of the Securities Exchange Act of 1934 preempts state bucket shop laws by providing that those laws shall not invalidate any put, call, straddle, option, privilege or other security “subject to this title” or apply to any activity that is incidental or related to the offer purchase, sale, exercise, settlement, or closeout of any such security.  This language is inexplicable.  In particular, what makes a security “subject to” the Exchange Act?  A narrow interpretation is that a security is subject to the Exchange Act only if it is of a class of securities registered or required to be registered under Section 12 of the Exchange Act.  However, some provisions apply to securities regardless of whether they are registered under Section 12.  Thus, it might be argued that any "security", as defined in Section 3(a)(10) of the Exchange Act, is “subject to” the Exchange Act.