Commentaries

Bridging the Week by Gary DeWaal: March 20 to 24 and March 27, 2017 (SARs and Red Flags; International Spoofing; Pre-Execution Discussions; Making Capital Markets Great Again)

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Published Date: March 26, 2017

Last week, a registered broker-dealer was charged by the Financial Industry Regulatory Authority for failing to consider whether problematic trading by certain direct market access clients that caused it to limit or stop their trading also warranted filing suspicious activity reports with the Financial Crimes Enforcement Network. Additionally, stock traders were substantially penalized in Singapore and China for engaging in spoofing-type conduct following first-of-their-kind enforcement activities by local authorities. Finally, Jay Clayton, President Trump’s nominee to serve as Chairman of the Securities and Exchange Commission, testified before a Senate committee that, if confirmed, he hoped to enhance US capital markets to make them more attractive to potential new issuers – perhaps by reducing regulations. As a result, the following matters are covered in this week’s edition of Bridging the Week:

Video Version:

Article Version

Briefly:

Compliance Weeds: Applicable law and FinCEN rules require broker-dealers and other covered financial institutions (banks, Commodity Futures Trading Commission-registered future commission merchants and introducing brokers and SEC-registered mutual funds) to file a SAR with FinCEN in response to transactions of at least US $5,000 which a covered entity “knows, suspects, or has reason to suspect” involve funds derived from illegal activity; have no business or apparent lawful purpose; are designed to evade applicable law; or utilize the institution for criminal activity. In August 2015, for example, FINRA fined Aegis Capital Corp US $950,000 for selling unregistered penny stocks and related supervisory violations, and suspended and fined two individuals – Charles Smulevitz and Kevin McKenna – who served successively as chief compliance and anti-money laundering officers for the firm. According to FINRA, Mr. Smulevitz and Mr. McKenna failed to “reasonably” detect and review red flags of potentially suspicious transactions. As a result, they did not make a “reasoned determination whether or not to report the suspicious transactions to the Financial Crimes Enforcement Network … by filing a Suspicious Activity Report … as appropriate.” (Click here for further details in the article “FINRA Fines and Suspends Two CCOs for Supervisory and AML Violations” in the August 14, 2015 edition of Bridging the Week.) Recently, FinCEN said that covered institutions might also have to file SARs following cyber-events. (Click here for background in the article “FinCEN Issues Advisory Saying Cyber Attacks May Be Required To Be Reported Through SARs in the October 30, 2016 edition of Bridging the Week.) Covered financial institutions should continually monitor transactions they facilitate and ensure they maintain and follow written procedures to identify and evaluate red flags of suspicious activities and file SARs with FinCEN when appropriate. (Click here for a helpful overview of anti-money laundering requirements for broker-dealers, including SAR requirements. Click here for a similarly helpful compilation of AML resources for members of the National Futures Association.) Moreover, covered institutions should ensure that problematic transactions identified by non-AML personnel (e.g., compliance staff) that may be violative of legal or regulatory standards are evaluated by AML personnel to determine whether a SAR should be filed with FinCEN. Indeed, the more of a consolidated ledger a firm can maintain of potential problems identified across otherwise separate surveillance functions, the more likely a firm will be able to recognize and act holistically upon material red flags.

My View: Last year, Michael Coscia, the first individual prosecuted and convicted under the provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act that expressly prohibits spoofing, was sentenced to three years in prison. This was after Mr. Coscia settled civil actions related to the same conduct with the Commodity Futures Trading Commission, the Financial Conduct Authority and the CME Group by payments of aggregate fines of approximately US $3.1 million; disgorgement of profits; and a one-year trading suspension. Subsequent to his sentencing, Mr. Coscia appealed his conviction to a Federal Court of Appeals where oral arguments were held on November 10, 2016. (Click here for background on Mr. Coscia’s alleged offenses, conviction, sentencing, and appeal in the article “Federal District Court Approves Flash Crash Spoofer’s US $38 Million Settlement; Federal Appeals Court Appears Sympathetic to Michael Coscia’s Claim That Spoofing Prohibition Is Too Vague” in the November 20, 2016 edition of Bridging the Week.) As I have written many times, although Mr. Coscia’s conduct may have been problematic, he was convicted under a provision of law that prohibits “spoofing” but defines it as “bidding or offering with the intent to cancel the bid or offer before execution.” However, many legitimate orders, including stop loss orders, are placed with the goal or hope not to have the order executed, as that would mean the value of a position is declining. The Federal District Court judge overseeing Mr. Coscia’s trial did not have a problem with the clarity of the relevant statute and, in any case, believed that Mr. Coscia should have known his specific trading was prohibited. Soon we should know what the Court of Appeals thinks.

My View: In 2015, a not-for-profit think tank headed by Paul Volcker, former Chairman of the Board of Governors of the Federal Reserve System, called for a substantial overhaul of the federal regulatory system that oversees US financial services, including merging the Commodity Futures Trading Commission and the Securities and Exchange Commission. Claiming that the oversight of US financial institutions “is highly fragmented, outdated, and ineffective,” the Volcker Alliance issued a report that recommended the creation of a so-called “twin-peaks” model of regulation. This paradigm would consolidate prudential oversight currently administered by a number of banking and financial regulators into one new independent federal agency—a prudential supervisory authority—and collapse the CFTC and the SEC’s investor protection and capital markets oversight functions into another new independent body. (Click here for background on the Volcker Alliance’s proposal in the article “Volcker Alliance Calls for CFTC and SEC Merger Among Other Financial Oversight Agencies’ Reform “ in the April 26, 2015 edition of Bridging the Week.) Paul Atkins, a former SEC commissioner and current advisor to President Trump, has also called for a merger of the CFTC and SEC. (Click here for the Statement of Mr. Atkins before the Committee on Financial Services of the House of Representative on September 15, 2011.) For me, the alphabet soup of federal agencies with oversight over financial firms, products and markets needs to be rationalized, and the CFTC and the SEC should long ago have been merged. It is solely a naming convention to label financial products as either futures or securities (and now swaps too), and a terrible mistake to base regulatory structure on the nomenclature of products rather than their essential characteristics and purposes. Hopefully, after new chairpersons of the CFTC and SEC are confirmed, a debate on what is the most effective and efficient means of regulating our nation’s markets and participants can begin.

Compliance Weeds: Generally, for approved Globex-traded contracts, CME Group permits pre-execution communications to facilitate trading subject to strict requirements. (Pre-execution communications are never permitted in connection with open outcry transactions with the sole exception of CME options on S&P futures undertaken in accordance with large order execution rules.) These requirements include that the party on whose behalf a communication is being made previously must have consented to such communication and that no person involved in pre-trade communications may take advantage of information conveyed except to facilitate the relevant trade. Unfortunately, CME Group rules regarding cross trades vary by product and by futures and options. Even the mechanical steps for executing a cross trade following a conversation varies. There are Globex Crosses, Agency Crosses, Committed Crosses, and RFQ and RFC Crosses too. However, despite the complexity, the consequences of getting it wrong can be severe, resulting in not only potential CME Group sanctions, but possible sanctions by the Commodity Futures Trading Commission too. Fortunately, hidden in the middle of the relevant Market Regulation Advisory Notice related to pre-execution communications is a link to a very helpful matrix of eligible products and associated crossing protocols (click here to access). (Click here for further background in the article “CME Group Updates Its Pre-Execution Communication Rule to Reflect New Committed Crosses” in the January 31, 2016 edition of Bridging the Week.)

And more briefly:

For further information:

Australian Regulator Announces How It Will Assess Service Providers Offering Digital Ledger Technology:
http://www.asic.gov.au/regulatory-resources/digital-transformation/evaluating-distributed-ledger-technology/

Brokerage Firms Fined Almost US $2 Million by HK Regulator for Position Reporting and Electronic Trading Systems Breaches:
http://www.sfc.hk/edistributionWeb/gateway/EN/news-and-announcements/news/openAppendix?refNo=17PR40&appendix=0

Clearing Firm’s Failure to File Suspicious Activity Reports in Response to Red Flags Charged as Violation of FINRA Requirements:
/ckfinder/userfiles/files/ETC%20FINRA%20Complaint%20March%202017.pdf

Commentators Generally Supportive of CFTC’s Proposed Record Retention Amendments:

FINRA to Industry: Can We Talk More?:
http://www.finra.org/sites/default/files/notice_doc_file_ref/Special-Notice-032117.pdf

Floor Broker and Former Floor Broker Settle CME Disciplinary Action Alleging Pre-Execution Arrangement of Customer Fill:

HK Regulator Amends Position Limit Regime: Rejects Blanket Hedging Exemption But Expands Excess Limits Regime:
http://www.sfc.hk/edistributionWeb/gateway/EN/consultation/conclusion?refNo=16CP3

Malaysian National Sentenced by Singapore Court to 16 Weeks Imprisonment for Stock-Based Spoofing; PRC Resident Fined by China Regulator for Similar Conduct:

Most Securities to Settle in Two Not Three Days Beginning September 5:
https://www.sec.gov/rules/final/2017/34-80295.pdf

SEC Chairman Nominee Urges Making US Capital Markets Great Again:
http://www.banking.senate.gov/public/index.cfm/hearings?ID=2AD621FA-1F08-4431-976A-44B821931775

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of March 25, 2017. No representation or warranty is made regarding the accuracy of any statement or information in this article. Also, the information in this article is not intended as a substitute for legal counsel, and is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The impact of the law for any particular situation depends on a variety of factors; therefore, readers of this article should not act upon any information in the article without seeking professional legal counsel. Katten Muchin Rosenman LLP may represent one or more entities mentioned in this article. Quotations attributable to speeches are from published remarks and may not reflect statements actually made.

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ABOUT GARY DEWAAL

Gary DeWaal

Gary DeWaal is currently Special Counsel with Katten Muchin Rosenman LLP in its New York office focusing on financial services regulatory matters. He provides advisory services and assists with investigations and litigation.


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