Bridging the Week by Gary DeWaal


Bridging the Week by Gary DeWaal: September 21 to 25 and 28, 2015 (Aggregation, Cybersecurity, Wash Sales, Fund Redemptions, IB Records, CTA Registration)

Bridging the Week    Compliance Weeds    Cybersecurity    Exchanges and Clearing Houses    Investment Advisers    Managed Money    My View    Position and Trade Reporting    Position Limits    Registration    Supervision    Trade Practices (including Disruptive Trading)   
Published Date: September 27, 2015

Many old themes re-emerged in the financial services industry last week. The Commodity Futures Trading Commission revised its proposed new rules dealing with the aggregation of accounts in connection with position limits, while the Securities and Exchange Commission brought an enforcement action against an investment adviser for failing to have a cybersecurity program to protect customer records and information. In addition, the SEC proposed rules to help ensure open-ended funds have enough liquidity to meet redemption demands during a crisis, while the CFTC brought two actions alleging impermissible wash sales – one against a swap execution facility. As a result, the following matters are covered in this week’s edition of Bridging the Week:

  • CFTC Revises Aggregation Proposal Related to Position Limits;
  • SEC Sanctions Investment Adviser for Not Implementing Policies and Procedures in Advance of Cyber-Attack (includes Compliance Weeds);
  • Former Investment Bank Financial Adviser Pleads Guilty to Illegally Accessing Confidential Client Information (includes Compliance Weeds);
  • Tera Exchange Consents to Cease and Desist Order by CFTC for Encouraging Wash Sale, No Fine Assessed:
  • SEC Seeks to Enhance Liquidity Management by Mutual Funds and ETFs;
  • Déjà Vu All Over Again – CFTC Settles Complaint With Cargill de Mexico for Wash Sales Following Similar CME Group Settlement (includes Compliance Weeds and My View);
  • Introducing Broker and COO Agree to Pay US $500,000 to Resolve CFTC Charges of Recordkeeping Violations and Supervision Breakdown;
  • CTA Fined US $280,000 by CFTC for Not Disclosing Principal and Changes to Algorithmic Trading System; and more.

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Article Version:

CFTC Revises Aggregation Proposal Related to Position Limits

The Commodity Futures Trading Commission revised its November 2013 proposal related to the aggregation of accounts in connection with its speculative position limits requirements.

Under its earlier proposal, the Commission would have required any entity owning more than 50 percent of another entity formally to apply to the Commission for approval to disaggregate positions of the other entity to the extent it may have qualified for relief.

Under the Commission’s new proposal, any qualified entity owning 10 percent or more of another entity up to 100 percent may file a notice of disaggregation, which would be effective upon submission. The notice would be required to include a description of the relevant conditions that warrant disaggregation and a certification by a senior officer that the conditions have been met.

In addition, under its earlier proposed aggregation rules the CFTC would have disallowed disaggregation for an owned entity if the entity was required to be and was consolidated in the financial statement of its ultimate owner. This provision has been eliminated in the new proposal because the CFTC found “merit” in arguments that “ownership of 50 percent interest in an entity (and the related consolidation of financial statements) may not mean that the owner actually controls day-to-day trading decisions of the owned entity.”

Generally, under the CFTC’s current aggregation rules, a person must combine all positions where it controls the trading decisions with all positions where the person has a 10 percent or more ownership interest in an account or position, as well as the positions of two or more persons acting according to an express or implied agreement. (Click here to access the CFTC’s current aggregation requirements – CFTC Regulation 150.4.) There are currently a number of potential exemptions to the CFTC aggregation requirements, including those pertaining to eligible entities with so-called independent account controllers; ownership interests of limited partners in pooled accounts; discretionary accounts; and customer trading programs of futures commission merchants.

In its November 2013 proposal, the Commission provided for persons meeting certain requirements to disaggregate positions of separately organized entities solely where the person’s ownership interest was between 10 and 50 percent. This ability would have been subject to a notice filing. (Click here for an overview of the CFTC’s November 2013 proposed aggregation rules in a November 7, 2013 Advisory entitled “CFTC Proposes Revised Aggregation Rules” by Katten Muchin Rosenman LLP.)

Under the new revised proposal, this capability is expanded to persons owning between 10 and 100 percent of another entity. Aggregation is still the “default requirement,” says the CFTC, unless a person (including any account such person must aggregate):

  • does not have knowledge of trading decisions of the other entity;
  • trades according to separately developed and independent trading systems;
  • has and enforces written procedures that prevent each from having knowledge of and gaining access to, or receiving information about, trades of the other (this would include document routing and other procedures or security arrangements including separate physical locations);
  • does not share employees that control the trading decisions of the other entity; and
  • does not have risk management systems that permit the sharing of trades or trading strategies.

The CFTC will maintain its other exemptions from its aggregation rules for eligible entities under its revised proposal.

Commissioner J. Christopher Giancarlo voted to approve the revised aggregation rule proposal along with CFTC Chairman Timothy Massad and Commissioner Sharon Bowen. However, Mr. Giancarlo expressed concern that the Commission’s proposed revised rule prohibited disaggregation where an owner and subsidiary entity has risk management systems that permitted the sharing of trades or trading strategies. According to Mr. Giancarlo,

[this] proposed rule may stymie critical risk-mitigation efforts. Owners and their affiliates may need to share information regarding trades or trading strategy to verify compliance with applicable credit limits as well as restrictions and collateral requirements for inter-affiliate transactions, among other risk-management and compliance related objectives.

Comments will be accepted by the CFTC on its revised aggregation rule proposals for 45 days after publication in the Federal Register. (Click here for further information on the CFTC proposed revised aggregation rules in the article “CFTC Proposes Revisions to Pending Aggregation Rules” in the September 28, 2015 Advisory by Katten Muchin Rosenman LLP.)

Briefly:

  • SEC Sanctions Investment Adviser for Not Implementing Policies and Procedures in Advance of Cyber-Attack: RT Jones Capital Equities Management, Inc., an investment adviser registered with the Securities and Exchange Commission, agreed to pay a fine of US $75,000 to resolve charges by the SEC for not having written cybersecurity policies and procedures to protect customer records and information in advance of a cyber-attack. According to the SEC, in July 2013, RT Jones’ third-party hosted web server was attacked by an unauthorized and unknown intruder who gained access and copy rights to data on the server. The SEC brought charges against RT Jones even though two consulting firms retained by the firm subsequent to the attack could not determine whether customer information was actually accessed or compromised, and the firm itself never learned of information indicating that any client had suffered any financial harm. Under the applicable SEC rule, said the Commission, RT Jones was obligated to implement written “policies and procedures reasonably designed” to ensure the security and confidentiality of customer records and information; protect against anticipated threats or hazards to such data; and protect against unauthorized access to such data that could cause “substantial harm or inconvenience to any customer.” (Click here to access the relevant SEC rule, Rule 30(a) of Regulation S-P.) RT Jones did not maintain such policies and procedures at the relevant time, claimed the Commission. The SEC noted that, since the cyber-attack, the firm has appointed an information security manager to oversee data security and customer information protection, and implemented a written information security program. (Click here for further information on this action in the article “SEC Enforcement Action Alleges an Adviser Failed to Adopt Adequate Cybersecurity Policies and Procedures; SEC Issues an Investor Alert on Data Theft” in the September 24, 2015 Advisory by Katten Muchin Rosenman LLP.)

Compliance Weeds: Expectations of regulators of registrants in both the securities and futures industry has been increasing during the past year regarding what cybersecurity protections should be in place to protect customer records and information. At the beginning of 2015, the SEC said it would focus on cybersecurity compliance and controls among its 2015 examination priorities for broker-dealers and investment advisers. (Click here for further details in the article “Cybersecurity, Potential Equity Order Routing Conflicts and AML Among the Top Examination Priorities for SEC in 2015” in the January 18, 2015 edition of Bridging the Week.) Just recently, on September 15, 2015, the SEC provided specific guidance on what it would look at in connection with these reviews. The SEC said it would focus on registrants’ governance and risk assessment related to cybersecurity; access rights and controls; data loss prevention; vendor management; training; and incident response. (Click here for further details in the article “SEC Discloses Elements of Cybersecurity Exams in the September 20, 2015 edition of Bridging the Week.) Also at the beginning of 2015, the Financial Industry Regulatory published a report identifying findings from its 2014 targeted examination of firms related to their cybersecurity practices and recommended practices broker-dealers should implement to minimize the impact of cybersecurity threats. (Click here for further details in the article “Industry Watchdogs Warn Brokers and Advisory Firms on Cybersecurity Threats” in the February 8, 2015 edition of Bridging the Week.) Moreover, last month, the National Futures Association submitted to the Commodity Futures Trading Commission for its approval a proposed Interpretive Notice requiring certain NFA members to maintain formal, written information systems security programs. Although the NFA made clear that its “policy is not to establish specific technology requirements,” it will require all relevant members to have supervisory procedures that are “reasonably designed to diligently supervise the risks of unauthorized access to or attack of their information technology systems, and to respond appropriately should unauthorized access or attack occur.” (Click here for further details, in the article “NFA Proposes Cybersecurity Guidance” in the September 13, 2015 edition of Bridging the Week.) Practically, any cyber breach that compromises customer personal information could leave an SEC or CFTC registrant vulnerable to an enforcement action if it had not previously adopted a written policy and procedure designed to minimize the threat of a cyber-attack and followed such procedure – whether or not an express requirement currently exists. (For additional information on how financial service firms might help protect themselves against cyber-threats, click here to access an Advisory entitled “Cyber-Attacks: Threats, Regulatory Reaction and Practical Proactive Measures to Help Avoid Risks” by Katten Muchin Rosenman LLP, dated June 24, 2015.)

  • Former Investment Bank Financial Adviser Pleads Guilty to Illegally Accessing Confidential Client Information: Galen Marsh, a former private wealth adviser associated with an unnamed investment bank, pled guilty last week to illegally accessing confidential data on approximately 73,000 clients of his former employer from June 2011 through December 2014. Among other things, Mr. Marsh was alleged to have uploaded information regarding these clients, including names, addresses, telephone numbers, account numbers, account values and other investment information, to a personal server at his home. Mr. Marsh was alleged to have used the identification numbers of other bank branches, production groups and financial advisers to gain the unauthorized access. Mr. Marsh will be sentenced on December 7, 2015. He faces a maximum of five years imprisonment and three years of supervised release.

Compliance Weeds: This matter is an example of why the greatest threat of cyber-attacks is from inside employees and consultants. Firms’ cybersecurity policies and procedures should address internal threats.

  • Tera Exchange Consents to Cease and Desist Order by CFTC for Encouraging Wash Sale, No Fine Assessed: The Tera Exchange was charged by the Commodity Futures Trading Commission of orchestrating two offsetting non-deliverable forward contracts based on the relative value of the US dollar and Bitcoin between two of its members in order to give the impression that bona fide trading had occurred (when it had not) in violation of its obligation to prohibit wash trading and pre-arranged trading. Tera’s obligations arose under core principles it is subject to as a CFTC provisionally registered swap execution facility, claimed the Commission. The transactions occurred on October 8, 2014. According to the CFTC, the trades were pre-arranged “with the understanding of the parties [that they] would execute a round-trip trade with the same price in, same price out (i.e., with no P/L consequences).” Following the transactions, on October 9, 2014, Tera issued a press release announcing “the first Bitcoin derivative transaction to be executed on a regulated exchange.” Also on the same day, October 9, the then president of Tera publicly disclosed the first transaction during a meeting of the CFTC’s Global Markets Advisory Committee, said the CFTC. To resolve this matter, Tera agreed to cease and desist from further violations. A fine, however, was not assessed as part of the resolution of the matter. CFTC Commissioner Sharon Bowen issued a rare dissent to this resolution. She said, “I believe fictitious trading deserves a penalty. The Exchange facilitated wash trading and prearranged trading… I fundamentally disagree with the notion that [Tera] deserve[s] no penalty.”
     
  • SEC Seeks to Enhance Liquidity Management by Mutual Funds and ETFs: The Securities and Exchange Commission proposed new rules to enhance liquidity management by open-ended funds (including mutual funds and open-ended exchange-traded funds but not money-market funds) and to enhance disclosure regarding fund liquidity and redemption practices. It also proposed rules to permit so-called “swing-pricing” by such entities. Swing pricing would permit open-ended funds to pass along the costs of redemptions and purchases to shareholders associated with the activity, once the level of net purchases into or net redemptions from a fund exceeded a specified percentage of its net asset value. Under the SEC’s proposal, all open-ended funds would be required to have a liquidity risk management program that included certain elements: classification of the liquidity of a fund’s portfolio assets; assessment, periodic review and management of a fund’s liquidity risk; establishment of a three-day liquid asset minimum; and board approval and review. The purpose of the proposed rules, said the SEC, “is aimed at decreasing the likelihood that funds would be unable to meet their redemption obligation and promote effective liquidity risk management industry-wide.” The SEC will accept comments to its proposals for 90 days following publication in the Federal Register.
     
  • Déjà Vu All Over Again – CFTC Settles Complaint With Cargill de Mexico for Wash Sales Following Similar CME Group Settlement: Cargill de Mexico SA agreed to pay a fine of US $500,000 to the Commodity Futures Trading Commission for executing wash sales on the Chicago Board of Trade and the Kansas City Board of Trade. According to the CFTC, on multiple occasions between March 2010 and August 2014, Cargill employees entered matching orders electronically for separate firm accounts, timing the opposite orders “to be as close to simultaneously as possible – often entering orders within less than a second.” The transactions involved CBOT corn, soybean and wheat futures contracts, and KCBT hard red wheat futures contracts. Cargill claimed it engaged in these transactions to transfer trades “in order to move hedging positions for its physical business among numerous accounts.” According to the CFTC, “Cargill de Mexico typically effected transfers between accounts by contacting its clearing broker and effecting transfers pursuant to the policies of the clearing broker and the rules of a designated contract market. However, in some instances, and in particular near or after the notice date, its clearing broker would not make the back office transfers due to applicable contract market rules. In these situations Cargill de Mexico traders transferred the positions using the market but did so in a non-competitive fashion by entering equal and opposite transactions.” In addition to paying a fine, to resolve this matter, Cargill also agreed to cease and desist from undertaking other non-competitive transactions in the future. Earlier this year, Cargill and two of its employees were fined US $80,000 in aggregate by CME Group for engaging in wash sales on six days between June 2013 and January 2014. CME Group alleged that, on these days, the two employees — Jesus Avila and Jose Gamboa — traded agricultural products involving opposite positions in the same delivery month when they “reasonably should have known” that the orders would trade against each other on Globex. The individual respondents also agreed to a five-day CME Group trading prohibition as part of their sanctions. (Click here for further details regarding the CME Group disciplinary action in the article “CME Group Sanctions Firm and Traders for Wash Sales Used to Transfer Positions and Another Firm for a Deficient Algorithm” in the March 1, 2015 edition of Bridging the Week.)

Compliance Weeds: Transfers of positions between non-independently controlled accounts of the same beneficial owner should be accomplished using the transfer rules of the relevant exchange, not through non-competitive trades, including exchange for related position transactions. (Click here for applicable CME rule (853), and here for applicable ICE Futures U.S. rule (4.11).)

My View: Just last week I noted that some would question why the CFTC would bring an enforcement action where an exchange had brought a materially identical disciplinary action previously. In the relevant case involving Robert McMahon, I concluded there likely was arguable justification for the CFTC's "me too" action in light of the fact the allegations involved fraud, and the relevant exchange could not ban the individual from trading on all exchanges but solely its own. (Click here to access full details in the article entitled, "Trader Fined US $171,000 by CFTC for Deceptive Trade Allocation Scheme Utilizing Block Trades; CME Group Previously Alleged Similar Wrongdoing" in the September 20, 2015 edition of Bridging the Week.) This case is different. Here the charges involve a few incidents of a discrete type of trade practice offense  wash sales  and there is no allegation of fraud or any widespread market offense, such as manipulation. As a result, even though the CME Group previously charged only offenses that occurred on its exchange (and not on the Kansas City Board of Trade), the exchange-action carried an appropriate sanction and conveyed an appropriate message. The CFTC's "me too" action here appears a misuse of scarce resources.

  • Introducing Broker and COO Agree to Pay US $500,000 to Resolve CFTC Charges of Recordkeeping Violations and Supervision Breakdown: Futures International LLC, an introducing broker registered with the Commodity Futures Trading Commission, and Amedeo Cerrone, its chief operating officer, settled charges brought by the CFTC that the firm failed to comply with applicable recordkeeping and supervisory requirements in connection with customer orders it executed from at least January 2009 to at least November 2012. The CFTC action was initially filed in a federal court in Illinois during October 2014. During the relevant time period, claimed to the Commission, the firm routinely failed to obtain or record order instructions from its customers in the form required by CFTC rules until after the orders were executed. Among other techniques, employees of the firm routinely time stamped blank order tickets and used these tickets to record required customer order information after the fact, in order to give the appearance they were prepared in accordance with CFTC requirements, said the Commission. Moreover, sometimes “FI employees executed trades without knowing what customer, if any, would eventually accept the trade,” said the Commission. Mr. Cerrone was charged as being responsible for each of FI's violations as a so-called "controlling person" of the firm. To resolve this matter, FI and Mr. Cerrone agreed to pay a combined fine of US $500,000 and to comply with applicable regulatory requirements going forward. (Click here to access information regarding a separate administrative action against one of FI’s principals in the article entitled “Former CBOT Floor Broker Fined US $200,000 by CFTC for Trading, Recordkeeping and Supervision Violations” in the October 12, 2014 edition of Bridging the Week.)
     
  • CTA Fined US $280,000 by CFTC for Not Disclosing Principal and Changes to Algorithmic Trading System: Nord Capital Advisors, a Commodity Futures Trading Commission-registered commodity trading adviser, and Yakov Shlyapochnik, a principal of NCA, were charged with failing to disclose that Nord Capital Financial Services Ltd. was also a principal of NCA from September 2011 through August 2014. During the time, claimed the CFTC, NCFS provided NCA the majority of its operating capital. In addition, both respondents were charged with disclosing that NCA used a particular algorithmic trading system from at least February 2013 until January 2014, when, in fact, it had discontinued using the system in November 2012. The firm stopped using the relevant trading system after its developer ceased working for NCA in November 2012 and withdrew its right to use the system, said the CFTC. To resolve this matter, respondents agreed to pay a fine of US $280,000 and be permanently prohibited from trading on CFTC overseen trading facilities.

And more briefly:

  • SEC Proposes to Permit Depositions in Administrative Proceeding and Other Changes to Rules of Practice: The Securities and Exchange Commission proposed amendments to its rules of practice that would attempt to make enforcement proceedings before an administrative tribunal more fair. These proposed changes would potentially extend the time before a hearing occurs in “appropriate” cases; permit parties to take depositions of witnesses in advance of a hearing; and require parties to submit filings and serve each other electronically. The SEC will accept comments on its proposed new rules for 60 days after publication in the Federal Register.
     
  • Circle Internet Financial Receives First NYDFS BitLicense: Circle Internet Financial Limited – which, according to its website, provides mobile apps aimed at helping greater ease-of-use in online and in-person payments as well as enhanced security and privacy for customers – obtained the first BitLicense granted by the New York State Department of Financial Services under its new BitLicense regulations adopted in June 2015. In general, NY’s BitLicense regulations require all financial intermediaries engaging in a virtual currency business to apply and obtain a so-called BitLicense, and to maintain certain minimum standards and programs to help ensure customer protection, cybersecurity and anti-money laundering compliance. (Click here for additional information in the article “NYDFS Issues BitLicense Framework for Regulating Virtual Currency Firms” in the June 7, 2015 edition of Bridging the Week.) Circle Internet is backed by Goldman Sachs, IDG Capital Partners, Breyer Capital, Oak Investment Partners and other investors.
     
  • Japan Securities Clearing Corporation Seeks CFTC Exemption From DCO Registration: The Japan Securities Clearing Corporation applied to the Commodity Futures Trading Commission for an exemption from registering as a derivatives clearing organization to clear swaps. Such exemption is available under law to non-US clearinghouses under comparable, comprehensive oversight by their host country as registered DCOs are by the CFTC. The CFTC will accept comments on JSCC’s application through October 2, 2015.
     
  • FIA Publishes REMIT Guidance for Market Participants Entering Into Certain European Wholesale Energy Transactions: The Futures Industry Association published a customer notice regarding REMIT registration and reporting requirements. REMIT, adopted in 2011, was designed to enhance the transparency and stability of European energy markets while prohibiting insider trading and market manipulation. Among other things, REMIT will require certain market participants to report certain exchange-traded wholesale energy products, including orders, to the Agency for the Cooperation of Energy Regulators beginning October 7, 2015. Over-the-counter wholesale energy transactions must be reported beginning April 7, 2016.
     
  • ‚ÄčNodal Clear Approved as Derivatives Clearing Organization: Nodal Clear, LLC was granted registration by the Commodity Futures Trading Commission as a derivatives clearing organization last week. It is authorized to clear contracts executed solely on or through Nodal Exchange, LLC, its affiliated designated contract market.

For more information, see:

CFTC Revises Aggregation Proposal Related to Position Limits:
http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/federalregister092215a.pdf

Circle Internet Financial Receives First NYDFS BitLicense:
http://www.dfs.ny.gov/about/press/pr1509221.htm

See also, Circle Internet website:
https://www.circle.com/en/investors

CTA Fined US $280,000 by CFTC for Not Disclosing Principal and Changes to Algorithmic Trading System:
http://www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfnordcapitalorder92415.pdf

Déjà Vu All Over Again – CFTC Settles Complaint With Cargill de Mexico for Wash Sales Following Similar CME Group Settlement:
http://www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfcargillorder92415.pdf

FIA Publishes REMIT Guidance for Market Participants Entering Into Certain European Wholesale Energy Transactions:
https://lc.fia.org/sites/default/files/content_attachments/Customer%20Notice%20Regarding%20REMIT%20Registration%20and%20Reporting.pdf

Former Investment Bank Financial Adviser Pleads Guilty to Illegally Accessing Confidential Client Information:

Complaint:
http://www.justice.gov/usao-sdny/file/777146/download
Announcement of Plea:
http://www.justice.gov/usao-sdny/pr/investment-bank-financial-adviser-pleads-guilty-manhattan-federal-court-illegally

Introducing Broker and COO Agree to Pay US $500,000 to Resolve CFTC Charges of Recordkeeping Violations and Supervision Breakdown:
http://www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/legalpleading/enffuturesorder092515.pdf

Japan Securities Clearing Corporation Seeks CFTC Exemption From DCO Registration:
http://www.cftc.gov/PressRoom/PressReleases/pr7238-15

Nodal Clear Approved as Derivatives Clearing Organization:
http://www.cftc.gov/PressRoom/PressReleases/pr7242-15

SEC Proposes to Permit Depositions in Administrative Proceeding and Other Changes to Rules of Practice:
http://www.sec.gov/rules/proposed/2015/34-75976.pdf
http://www.sec.gov/rules/proposed/2015/34-75977.pdf

SEC Sanctions Investment Adviser for Not Implementing Policies and Procedures in Advance of Cyber-Attack:
http://www.sec.gov/litigation/admin/2015/ia-4204.pdf

See also, Investor Alert:
http://www.sec.gov/oiea/investor-alerts-bulletins/ia_databreaches.html

SEC Seeks to Enhance Liquidity Management by Mutual Funds and ETFs:
http://www.sec.gov/rules/proposed/2015/33-9922.pdf

Tera Exchange Consents to Cease and Desist Order by CFTC for Encouraging Wash Sale, No Fine Assessed:
http://www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfteraexchangeorder92415.pdf

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of September 26, 2015. 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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