Bridging the Weeks by Gary DeWaal: February 12 to 23, and February 26, 2018 (Whistleblowers; AML Staffing; Unlicensed Crypto Exchange; FCA-CFTC FinTech Cooperation)

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Published Date: February 25, 2018

The United States Supreme Court made clear that, to take advantage of a key anti-retaliation protection of the Dodd-Frank Wall Street Reform and Consumer Protection Act, an employee whistleblower must identify potential securities law violations to the Securities and Exchange Commission, and not solely to his/her employer. This is not a good outcome for businesses. Separately, a bank was sanctioned over US $600 million by four federal regulators for not employing a sufficient number of anti-money laundering personnel, and capping the number of exception reports generated by its AML surveillance system to accommodate the reduced number of AML employees. Also, one non-United States financial services regulator endeavored to succinctly distinguish the functionality of different types of digital tokens that might be issued in connection with an initial coin offering and disclosed its current regulatory approach to each. As a result, the following matters are covered in this week’s edition of Bridging the Weeks:

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My View: This Supreme Court decision is not a favorable outcome for companies. No longer can an individual raise a concern with his/her employer regarding a potential securities law violation, knowing he/she has six years to file a lawsuit in a federal court if he/she subsequently believes that retaliatory measures were taken.  Instead such potential violation must be identified to the SEC. This could discourage employees to raise concerns exclusively with his/her employer. As a result, companies should consider this when adopting whistleblowing policies in order to encourage employees, notwithstanding, to raise potential securities law issues internally – although they must be careful not to engage in any activity or require the execution of any agreement – that limits employees’ federal law rights.

The SEC has actively pursued enforcement actions against firms that utilized confidentiality agreements that the agency believed discouraged employees from reporting potential violations of federal securities laws to it. (Click here for an overview of these enforcement actions in the article “More Firms Sanctions for Whistleblower Offenses by SEC” in the January 29, 2017 edition of Bridging the Week.)

Last year, the Commodity Futures Trading Commission amended its whistleblowing rules to augment anti-retaliation protections for whistleblowers. Simultaneously, the CFTC issued guidance that said it had the authority to bring enforcement actions against violators of its anti-retaliation rules, revoking a contrary 2011-issued interpretation. (Click here for background in the article “CFTC Strengthens Protections for Whistleblowing While You Work” in the June 4, 2017 edition of Bridging the Week.)

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 July 2017, Electronic Transaction Clearing, Inc., a registered broker-dealer, agreed to settle charges brought by the Financial Industry Regulatory Authority that it failed to consider whether to file suspicious activity reports, as required, in response to red flags of possible suspicious conduct as well as for other violations. According to FINRA, ETC did not file such reports even after it restricted trading by certain of its customers after 30 instances where the firm identified problematic conduct, including prearranged trades or trading without an apparent economic reason. ETC agreed to pay a fine of US $250,000 to resolve FINRA’s charges. (Click here for background regarding FINRA’s charges in the article “Clearing Firm’s Failure to File Suspicious Activity Reports in Response to Red Flags Charged as Violation of FINRA Requirements” in the March 26, 2017 edition of Bridging the Week.)

Covered financial institutions should continually monitor transactions they facilitate; 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 violate legal or regulatory standards are evaluated by AML personnel to determine whether a SAR should be filed with FinCEN. Indeed, the more consolidated a 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. Sounds like a great potential application of distributed ledger technology!

Unrelatedly, the SEC suspended trading in three companies that claimed they were involved with cryptocurrencies and blockchain technology because of concerns regarding “the nature of the companies business operations and the value of their assets.” The companies are: Cherubim Interests Inc., PDX Partners Inc. and Victura Construction Group Inc.

My View: As I indicated a few weeks ago, the SEC takes a very broad view of what constitutes a security. This view is principally premised on the agency’s interpretation of the landmark 1946 Supreme Court decision of SEC v. W.J. Howey (click here to access) that labeled as an investment contract (and thus, as a security) any (1) investment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) to be derived solely from the entrepreneurial or managerial efforts of others. The SEC argues that an investment contract could also exist when persons invest money in a project and expect profits through the appreciation in value of their investment attributable to the entrepreneurial or managerial efforts of others, even if such “profits” can be realized solely by investors reselling their investments. As a result, the SEC argues that an investment contract could include instruments that convey no traditional ownership rights on its holders or any direct rights to revenue – such as many digital tokens issued as part of ICOs. (Click here for background on the SEC’s views in the article “Non-Registered Cryptocurrency Based on Munchee Food App Fails to Satisfy SEC’s Appetite for Non-Security” in the December 17, 2017 edition of Bridging the Week.)

However, as I argued at a meeting of the Technology Advisory Committee of the Commodity Futures Trading Commission on February 14, under this approach, privately issued gold coins promoted by their issuers could potentially be deemed investment contracts by the SEC, as could special edition collectible automobiles hyped by their manufacturers. (Click here to access a video of the CFTC’s February 14 TAC meeting.) In these instances, purchasers would reasonably expect to realize a premium to ordinary market value if they resell their asset because of the entrepreneurial or managerial efforts of others designed to create buzz around their asset. This seems like an attenuated view of what should be considered a security, but it appears consistent with the SEC’s current reasoning. This view could potentially capture some virtual currencies within the definition of a security as well. (Click here to see this possibility raised in Question 9 in the CFTC’s request for comment in connection with its proposed guidance on “actual delivery” for retail commodity transactions involving virtual currencies (December 20, 2017) – at page 60341.)

Two weeks ago, the Swiss Financial Market Supervisory Authority (FINMA) endeavored to provide some clarity of its own oversight of different types of digital tokens – which it named "payment tokens," "utility tokens" and "asset tokens." (Click here to access the relevant FINMA guidance.) The regulator claimed that it was not the issuance of a token through an initial coin offering that made it a security; rather, it was the nature of the token that was issued.

According to FINMA, payment tokens are tokens intended to be used now or in the future as a means to acquire goods or services, or as a means of money or value transfer. Because such tokens are meant to act as a means of payment “and are not analogous in their function to traditional securities,” FINMA indicated that, going forward, it would not treat payment tokens (e.g., Bitcoin, Ether) as securities.

FINMA said that asset tokens represented assets such as a debt or equity claim on an issuer, or which enabled assets to be traded on a blockchain. These tokens would be treated as securities. Also, pre-financing and pre-sale phases of initial coin offerings that grant rights to acquire tokens in the future, would also be regarded as securities.

FINMA defined utility tokens as tokens “intended to provide access digitally to an application or service by means of a blockchain-based infrastructure.” The regulator indicated it would not consider utility tokens as securities if the tokens’ “sole purpose” was to confer digital access rights at the time of issue. However, if a utility token could additionally or only have an investment purpose at the time of issue, it would be treated as an asset token too.

Unfortunately, after providing some clearer lines than currently exists in the United States, FINMA muddied the waters by indicating that asset and utility tokens could also be payment tokens (i.e., hybrid tokens). In such cases, said the regulator,” the requirements are cumulative; in other words the tokens are deemed to be both securities and means of payment.”

However, there needs to be bright lines regarding the classifications of tokens to avoid the imposition of cumulative laws that could have the unintended consequence of stifling the development of decentralized distributed ledger technologies and applications as well as leaving investors unclear what they are purchasing and selling. FINMA has usefully advanced the dialogue by proposing some clearer tests to differentiate the nature of tokens; hopefully others can further this dialogue.

My View: In the last two weeks, multiple international regulators have issued cautions and advisories regarding cryptocurrencies. Among other advisories,

Separately, seven of the largest cryptocurrency enterprises in the United Kingdom, including Coinbase, have formed a trade organization known as CryptoUK. The goal of the organization is “to help educate politicians and regulators about the cryptocurrency industry, to work with them in developing an appropriate operating framework in the UK.” Among other things, the members expressly support “the introduction of appropriate regulation” and have adopted a code of conduct that calls for members to commit to operate “honestly and responsibly” with consumers; to communicate with customers in a way that is “fair, clear and not misleading”; and to include on platforms information regarding the complaints procedure, the senior management team, the legal form of the business, arrangements in case of business failure, and material changes in business, among other information. (Click here to access CryptoUK’s Key Principles and Code of Conduct.)

The media has reported that a move to create a self-regulatory organization in Japan comprising 16 of the country’s cryptocurrency exchanges may be finalized as soon as this week. (Click here for a sample article describing this development.)

At the February 14 CFTC TAC meeting, Commissioner Brian Quintenz called for the consideration of whether the “SRO model could assist cryptocurrency exchanges establish and enforce standards that protect investors and deter fraud.” (Click here for a copy of Mr. Quintenz’s prepared remarks.)

To be a truly credible SRO, an organization should not only have a code of conduct but an effective means of disciplining members for breach of the code, as well as the authority to investigate their ongoing conduct. It should likely also have more specific proscriptions. However, the initiatives being taken in the United Kingdom and apparently in Japan are important first steps and are highly welcome.

Separately, the UK Financial Conduct Authority issued a report summarizing good and bad practices for algorithmic traders, addressing five principle topics: defining algorithmic trading, development and testing, risk controls, governance and oversight, and market conduct. For example, because firms need to identify algorithmic trading across their entire business in order to comply with new requirements under the Markets in Financial Instruments Directive II, a good practice is to consult all aspects of a business in order to “consider at length how trading algorithms are used within the firm.” This technique enables a firm to ensure that all relevant activities are captured, observed the FCA. A poor practice, said the FCA, is for a business to use a “high level definition” which may capture algorithms used in well-established areas, but not other areas where algorithms are used less frequently. FCA also considers it a good practice to have robust development and testing procedures that includes breaking down the development process into separate components to establish independent tests at each phase. A bad practice, submits FCA, is for firms not to apply their development and testing procedures across all aspects of their business. Another good practice is to consider the impact of algorithmic trading strategies and whether “the proposal is deemed appropriate.” A poor practice would be to focus on operational effectiveness and not consider market conduct considerations.

Compliance Weeds: Other regulators besides SFC are concerned with potentially disruptive trading caused by algorithmic trading systems. Last year, Saxo Bank A/S, a member firm, agreed to pay an aggregate fine of US $190,000 to the Chicago Board of Trade and the Chicago Mercantile Exchange to resolve two disciplinary actions brought against it for the way it liquidated futures positions of its customers that were under-margined. According to the exchanges, on multiple dates between October 2014 and March 2015, Saxo employed a liquidation algorithm that automatically entered market orders for the entire amount of an under-margined customer’s positions. The exchanges said Saxo Bank did so without considering market conditions and therefore violated its disruptive trading practices rule. (Click here for background in the article “CME Group Settles Disciplinary Action Alleging That Automatic Liquidation of Under-Margined Customers Positions by Non-US Futures Broker Constituted Disruptive Trading” in the March 20, 2017 edition of Bridging the Week.)

Persons entering orders on CME Group and other exchanges must be mindful of the potential impact of their orders on the marketplace and avoid actionable or nonactionable messages that are likely to have a disruptive impact on the marketplace.

Separately, Stone Ridge Asset Management LLC agreed to pay a fine of US $45,000 and Raymond Simpson consented to pay a sanction of $25,000, both to the Chicago Mercantile Exchange, to resolve unrelated disciplinary actions. Stone Ridge was charged with engaging in exchange for related position transactions involving NASDAQ 100 and E-mini S&P futures that were dependent on other transactions that were immediately offset, while Mr. Simpson was charged with wash trades for entering into buy and sell transactions to freshen positions. In connection with his trades, Mr. Simpson also allegedly permitted another person to use his Tag 50 ID to enter orders that Mr. Simpson controlled; each individual must use their own Tag 50 ID in connection with Globex orders. (Click here to access CME Group Rule 576 within a relevant Market Regulation Advisory Notice published by the exchange.) Mr. Simpson also agreed to a 15-business-day all CME Group trading prohibition as part of his settlement.

Ecom Agroindustrial Corp. Limited also agreed to pay a fine of US $20,000 to resolve a disciplinary action alleging that it engaged in two instances of wash sales on December 27, 2016, to effectuate position transfers. Soars Capital Limited was ordered to pay a fine of US $100,000 for failing to answer charges against it that it engaged in disruptive trading practices on various occasions from September 18, 2015, through March 7, 2016.

Legal Weeds: Last month, the Commodity Futures Trading Commission and the Department of Justice coordinated announcements regarding the filing of civil enforcement actions by the CFTC, naming five corporations and six individuals, and criminal actions by the DOJ against eight individuals – including six of the same persons named in the CFTC actions – for engaging in spoofing activities in connection with the trading of futures contracts on US markets.

Four of the corporations – part of global banking organizations – simultaneously resolved their CFTC-brought civil actions. These four corporations were Deutsche Bank AG and its wholly owned subsidiary Deutsche Bank Securities Inc., UBS AG and HSBC Securities (USA), Inc. DB and DBSI settled their CFTC enforcement actions by agreeing to jointly and severally pay a fine of US $30 million; UBS settled by consenting to a sanction of US $15 million; and HSBC settled by agreeing to a fine of US $1.5 million. The companies additionally agreed to continue to maintain surveillance systems to detect spoofing; ensure personnel “promptly” review reports generated by such systems and follow up as necessary if potential spoofing conduct is identified; and maintain training programs regarding spoofing, manipulation and attempted manipulation. (Click here for details in the article “CFTC Names Four Banking Organization Companies, a Trading Software Design Company and Six Individuals in Spoofing-Related Cases; the Same Six Individuals Criminally Charged Plus Two More” in the February 4, 2017 edition of Bridging the Week.)

Subjects of exchange investigations and disciplinary actions must consider the consequences of their cooperation should they later be subject to a criminal action. Information and testimony provided in an exchange investigation or action can be used to incriminate a person in such later criminal action – which might lead to substantial fines and imprisonment. However, the consequences of noncooperation at the exchange level can also be profound, leading potentially to large fines and suspension of all trading privileges.

More Briefly:

For further information:

Bank Sanctioned US $613 Million for Capping Number of Suspicious Activity Reports:

CFTC and UK FCA Agree to Cooperate in Supporting Innovative FinTech Businesses:

CFTC Proposes to Simplify Layout of Definitions in Regulations:

CFTC’s DSIO Grants Temporary IB Registration Relief to ICE Subsidiary to Accommodate Transfer of Energy Contracts From ICE Futures Europe to ICE Futures US:

HK SFC Fines Brokerage Company HK $4.5 Million for Order Routing System Breakdown; UK FCA Publishes Observations on Best Practices in Algorithmic Trading:

FinCEN Updates Lists of Problematic Jurisdictions:

ICE Futures Singapore Approved for Direct Access by US Persons by CFTC:

ICE Futures US Sanctions Trader US $100,000 For Alleged Spoofing Offense:

CME Group:

ICE Futures US:

SEC Issues Guidance to Public Companies Regarding Cybersecurity Disclosure:

SEC Sues Bitcoin-Denominated Trading Platform for Operating an Unlicensed Securities Exchange; Principal Criminally Charged:

Trading Suspended:

Unlicensed Exchange:

Supreme Court Narrows Key Whistleblowing Protection:

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of February 24, 2018. 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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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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