Bridging the Week by Gary DeWaal

There was little international regulatory activity involving the financial services industry last week. The Chairman of the Commodity Futures Trading Commission discussed his 2016 priorities at an industry gathering of lawyers, and one big surprise was that position limits were barely mentioned. In Canada, regulators proposed collateral protection rules for cleared over-the-counter derivatives. Back in the United States, it was the CFTC itself that received a qualified opinion by an accounting firm regarding its fiscal years 2014 and 2015 financial statements, and a finding that it had a material inadequacy in internal controls. As a result, the following matters are covered in this week’s edition of Bridging the Week:

• Kraft Foods Seeks to Appeal Trial Court Ruling on CFTC Manipulation Theories;
• CFTC Objects to Consideration of Industry Friend of Court Brief in DRW Lawsuit;
• Chairman Massad Says Finalizing Reg AT and Rules on Cybersecurity and Improving Swap Data Reporting Are 2016 CFTC Priorities; Position Limits Barely Get a Mention;
• Fund Manager Sanctioned by SEC for Overcharging Fees and Misleading Investors About Asset Valuation;
• Canadian Regulators Propose Collateral Protection Rules for Cleared OTC Derivatives; and more.

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Briefly:

• Kraft Foods Seeks to Appeal Trial Court Ruling on CFTC Manipulation Theories: Kraft Foods Group, Inc. and Mondelez Global LLC requested permission from the federal court hearing the enforcement action by the Commodity Futures Trading Commission against them for alleged manipulation to have a federal appeals court rule on two of the Commission’s central legal theories. These are whether (1) “a defendant’s large futures position, coupled with an alleged intent to affect market prices but absent any other false communication’s to the market” is prohibited “false signaling” manipulation and (2) whether the prices that result following a defendant’s purchases of futures positions in a market that cause futures and cash prices to converge are artificial prices. Defendants claim that an appellate court’s determination of these questions at this time would assist the court hearing the CFTC action to “properly” determine certain of defendant’s pretrial motions and to ensure that jurors receive proper instructions at trial. In April 2015, the CFTC filed a lawsuit against defendants claiming that wheat futures trades they entered on the Chicago Board of Trade for the alleged purpose of hedging were in fact entered for the purpose of artificially lowering prices in the related cash market. The CFTC accused the companies of engaging in manipulation and attempted manipulation through their activities, as well as engaging in a “manipulative or deceptive device or contrivance." Under law, the former allegation traditionally requires proof of intent and an artificial price, among other elements, while the latter does not. (Click here for details regarding the CFTC’s lawsuit in the article, “Manipulation Is Not Hedging Says CFTC in Federal Court Lawsuit Against Kraft Foods Group and Mondelez Global” in the April 5, 2015 edition of Bridging the Week.) Defendants previously argued that at least two of the counts of the CFTC’s complaint should be dismissed because the pleadings did not describe how the defendants allegedly deceived the market and because the CFTC failed to plead that the firms’ conduct caused an artificial price and they had the requisite specific intent. (Click here for details regarding the defendants’ motion to dismiss in the article, “Kraft Foods and Mondelez Global Seek to Dismiss Parts of CFTC’s Manipulation Complaint” in the June 7, 2015 edition of Bridging the Week.) The court denied defendants’ motion. (Click here for details regarding the court’s denial of defendant’s motion in the article, “Global Food Merchant’s Motion to Dismiss CFTC’s Enforcement Action for Alleged Manipulation Denied” in the December 20, 2015 edition of Bridging the Week.)
   
• CFTC Objects to Consideration of Industry Friend of Court Brief in DRW Lawsuit: The Commodity Futures Trading Commission opposed the request of five industry organizations to assist the federal court hearing the CFTC’s pending lawsuit against Donald Wilson and DRW Investments, LLC, alleging attempted manipulation, in its evaluation of the correct legal standard to apply to evaluate respondents’ conduct. Two weeks ago, the five industry organizations—CME Group, Commodity Markets Council, Futures Industry Association, Intercontinental Exchange and Managed Futures Association—asked the court for permission to weigh in and argue that the CFTC should be required to prove—consistent with prior case law—that respondents intended to create an artificial price—one “that does not reflect the legitimate forces of supply and demand”—not solely to affect price, as the CFTC charged. This was necessary, said the organizations, because “market participants have a right to trade in their own best interests without regard to the positions of others as long as their trading activity does not have as its purpose the creation of ‘artificial’ or ‘distorted’ prices.” (Click here for a discussion of the substance of the organizations' petition in the article, “Industry Groups Seek to Help Court Hearing the CFTC Enforcement Action Against DRW Regarding What Constitutes Attempted Manipulation” in the January 18, 2016 edition of Bridging the Week.) The CFTC said the organizations’ request to provide assistance should be rejected because “Amici’s proposed brief offers the Court nothing new” and was untimely.
   
• Chairman Massad Says Finalizing Reg AT and Rules on Cybersecurity and Improving Swap Data Reporting Are 2016 CFTC Priorities; Position Limits Barely Get a Mention: Timothy Massad, Chairman of the Commodity Futures Trading Commission, heralded the CFTC’s upgrading of the registration status of 18 swap execution facilities from temporary to permanent and the finalizing of its margin rules for uncleared swaps as two of the agency’s most important recent actions. (Click here to see a related article in this edition of Bridging the Week on SEFs’ registration.) He made this observation last week before the American Bar Association’s Derivatives and Futures Law Committee’s 2016 Winter Meeting. He noted that the CFTC’s margin rules are “practically the same” as similar rules adopted by other prudential regulators and “very similar” to international standards and rules he expected regulators in Europe and Japan soon to adopt. Mr. Massad indicated that, in 2016, priorities of the CFTC include finalizing rules on algorithmic trading, as well as cybersecurity for exchanges, clearing houses and swap data repositories, and improving swap data reporting. Mr. Massad did not expressly state that finalizing proposed rules on position limits was a priority for 2016. Instead, towards the end of his prepared speech, he simply referenced that “[t]here is a significant amount of work going on in other areas, including position limits, enforcement and a host of other activities.”
   
• Fund Manager Sanctioned by SEC for Overcharging Fees and Misleading Investors About Asset Valuation: Equinox Fund Management, LLC agreed to refund investors US $5.4 million plus interest and pay a fine of US $400,000 to resolve charges by the Securities and Exchange Commission that from 2004 through March 2011 it overcharged management fees and valued assets in a manner contrary to the methodology disclosed to investors. According to the SEC, during the relevant time, Equinox—an asset management firm that specializes in managed futures—promised to base management fees on net asset value, but in fact assessed fees based on notional trading value (including leverage). Moreover, said the SEC, certain of the firm’s filings with it in 2010 and 2011 misstated the firm’s valuation practices related to certain derivatives. For example, the firm stated that its valuation of certain derivatives was “corroborated by weekly counterparty settlement values” when, in fact, the firm received information during the relevant time evidencing that its valuation was higher than the counterparty’s valuation, claimed the SEC. Equinox did not admit or deny any of the SEC’s findings as part of its settlement. Equinox is registered with the SEC as an investment adviser and as a commodity pool operator with the Commodity Futures Trading Commission. 
   
• Canadian Regulators Propose Collateral Protection Rules for Cleared OTC Derivatives: Members of the Canadian Securities Administrators published their proposal to protect customer collateral in connection with the clearing of over-the-counter derivatives. Proposed requirements address the collection and mandatory segregation of customer collateral; recordkeeping requirements; and restrictions on the use and investment of customer collateral. CSA’s proposal also provides a framework to encourage the transfer of customer positions and collateral in the case of an intermediary’s default or insolvency. CSA additionally recommends “substituted compliance in specified circumstances where a foreign entity is involved in a transaction and appropriate foreign laws apply.” Comments will be accepted by each CSA member through April 19, 2016. CSA, made up of securities regulators of Canada’s provinces and territories, coordinates and harmonizes capital markets regulation in Canada.

And more briefly:

• Eighteen SEFs Finally Fully Registered by CFTC: Eighteen swap execution facilities were given full registration last week by the Commodity Futures Trading Commission as opposed to continuing to operate under a temporary registration status. The 18 SEFs are: BGC Derivatives Markets, L.P.; Bloomberg SEF LLC; Chicago Mercantile Exchange Inc.; DW SEF LLC; GFI Swaps Exchange LLC; ICAP Global Derivatives Limited; ICAP SEF (US) LLC; ICE Swap Trade, LLC; Javelin SEF, LLC; LatAm SEF, LLC; MarketAxess SEF Corporation; SwapEx, LLC; Thomson Reuters (SEF) LLC; tpSEF Inc.; Tradition SEF, Inc.; trueEX LLC; 360 Trading Networks Inc.; and TW SEF LLC.
   
• CFTC Staff Reminds FCMs and SDs That Are Banking Entities to Address Volcker Compliance in CCO Annual Report: The Division of Swap Dealer and Intermediary Oversight issued a Staff Advisory reminding futures commission merchants and swap dealers that are part of banking entities to include reference to their Volcker Rule compliance as part of their CCO annual reports for fiscal years ending after July 21, 2015. Both SDs and FCMs must prepare and file with the CFTC annual reports of their compliance prepared by their chief compliance officer and certified by the CCO or the chief executive officer of the organization within 90 days of their fiscal year-end. (Click here to access CFTC Rule 3.3(e), which addresses CCO annual reports by SDs, major swap participants and FCMs.)
   
• FINRA Requires Firms to Maintain Procedures for Backup OTC Reporting in Case of Systems’ Breakdown: The Financial Industry Regulatory Authority issued guidance that firms must have written procedures addressing how they will deal with over-the-counter trading and reporting of equities during a trading day if they are unable to connect with a FINRA reporting facility for any reason—whether a cause individualized to the firm, or a systemic failure. Under certain circumstances, the procedure should require the firm to cease OTC trading completely. Under FINRA rules, firms must report OTC transactions in equity securities as soon as possible but by no later than 10 seconds following execution.
   
• EC Urges ESMA to Complete Assessment of Marketing Passport for Nine Countries, Including US: The European Commission has instructed the European Securities and Markets Authority to complete its assessment of the rules of nine countries, including the United States, to assess whether their managers and funds should be permitted access to European customers based on being subject to comparable regulation. The EC asked ESMA to complete its review by June 30, 2016. This access is potentially available under a passport scheme contemplated by the European Union’s Alternative Investment Fund Managers Directive.

And finally:

• Totally Irrelevant (Or Is It?) – KPMG Issues Only a Qualified Opinion to the CFTC for Its 2014 and 2015 Financial Statements and Finds a Material Weakness in the CFTC’s Internal Controls: The Commodity Futures Trading Commission received only a “qualified opinion” for its financial statement as of September 30, 2015, and 2014 (the end of its fiscal years) by KPMG LLP, in connection with an audit conducted by the Office of Inspector General. Moreover, KPMG found a material weakness in the CFTC’s internal controls over its financial presentation. Specifically, KPMG contested the manner in which the CFTC accounted for long-term lease obligations, claiming it understated its going-forward obligations by US $212 million in FY 2014 and US $194 million in FY 2015. The CFTC did not agree with KPMG’s findings, saying its “historical practice has been to obligate only the annual portion of lease payments due each year.” The CFTC said it based its presentation on advice from the Office of Management and Budget and anticipates a formal view from the Government Accountability Office later this year. KPMG also found two other reporting errors in the CFTC’s FY 2014 financial presentation that the CFTC subsequently corrected. KPMG claimed the CFTC’s internal controls were deficient because the agency did not have adequate measures to ensure lease obligations were reflected in accordance with Generally Accepted Accounting Principles and it lacked “sufficiently detailed review by management of the financial statements” to ensure that errors and omissions were caught. Among other things, KPMG recommended the CFTC “[d]evelop written accounting policies and procedures that document the basis for all accounting positions that are significant to the financial statements.” KPMG’s current view of the CFTC’s financial position as of September 30, 2014, reversed its view at the time when it said the Commission’s presentation of its financial position was “fairly stated.” Imagine the consequences of KPMG’s conclusions if the CFTC was a registrant under its own jurisdiction. Ouch!

For more information, see:

Canadian Regulators Propose Collateral Protection Rules for Cleared OTC Derivatives:
https://www.osc.gov.on.ca/en/SecuritiesLaw_csa_20160121_94-102_derivatives-customer-collateral.htm

CFTC Objects to Consideration of Industry Friend of Court Brief in DRW Lawsuit:
/ckfinder/userfiles/files/CFTC%20DRW%20Response.pdf

CFTC Staff Reminds FCMs and SDs That Are Banking Entities to Address Volcker Compliance in CCO Annual Report:
/ckfinder/userfiles/files/DSIO%20CCO%20Volcker%20Advisory.pdf

Chairman Massad Says Finalizing Reg AT and Rules on Cybersecurity and Improving Swap Data Reporting Are 2016 CFTC Priorities; Position Limits Barely Get a Mention:
http://www.cftc.gov/PressRoom/SpeechesTestimony/opamassad-37

EC Urges ESMA to Complete Assessment of Marketing Passport for Nine Countries, Including US:
/ckfinder/userfiles/files/EU%20ESMA%20AIFMD%20Letter.pdf

Eighteen SEFs Finally Fully Registered by CFTC:
http://www.cftc.gov/PressRoom/PressReleases/pr7313-16

FINRA Requires Firms to Maintain Procedures for Backup OTC Reporting in Case of Systems’ Breakdown:
http://www.finra.org/sites/default/files/notice_doc_file_ref/Trade-Reporting-Notice-012016.pdf

Fund Manager Sanctioned by SEC for Overcharging Fees and Misleading Investors About Asset Valuation:
http://www.sec.gov/litigation/admin/2016/33-10004.pdf

Totally Irrelevant (Or Is It?) – KPMG Issues Only a Qualified Opinion to the CFTC for Its 2014 and 2015 Financial Statements and Finds a Material Weakness in the CFTC’s Internal Controls:
/ckfinder/userfiles/files/CFTC%20Accounting.pdf

Kraft Foods Seeks to Appeal Trial Court Ruling on CFTC Manipulation Theories:
/ckfinder/userfiles/files/Kraft%20Memo%20to%20Support%20Appeal.pdf

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of January 23, 2016. 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.