Bridging the Week by Gary DeWaal


Bridging the Week by Gary DeWaal: May 9 - 13 and May 16, 2016 (Personal Liability; Rogue Trader; Hubris Risk; Spoofing)

Bridging the Week    Canadian Regulation (sans Capital and Liquidity)    Compliance Weeds    Culture and Ethics    Customer Protection    Cybersecurity    Fraud and Anti-Fraud    Insider Trading    My View    Trade Practices (including Disruptive Trading)    Uncleared Swaps   
Published Date: May 15, 2016

Last week a futures commission merchant and its controller were both named in an enforcement action by the Commodity Futures Trading Commission for their alleged failure to immediately file a notice with the CFTC when, for one night, the firm failed to have sufficient customer funds in segregation and enough of its own funds in a customer segregated account as a buffer, following a clerical error. In addition, the principal financial regulator of Dubai barred a rogue trader who hid approximately US $11 million of trading losses through position mismarking, while the incoming head of the UK Financial Conduct Authority identified “hubris risk” as a dangerous risk firms can only mitigate through adoption of a good culture. As a result, the following matters are covered in this week’s edition of Bridging the Week:

  • Controller of FCM Named in CFTC Complaint, Along with Firm, for Failure to Timely Notify Commission of Segregation Breach (includes Compliance Weeds and My View);
  • Dubai-Based Trader Barred by DFSA for Hiding Trading Losses of US $11 Million by Mismarking Positions (includes Culture and Ethics);
  • Incoming FCA Head Identifies “Hubris Risk” As Among the Risks Banks Can Mitigate Only Through a Strong Culture;
  • Alleged Spoofer in CFTC Enforcement Action Claims Relevant Statute and Regulation Unconstitutionally Vague (includes My View);
  • Broker-Dealer Sanctioned by FINRA for Alleged Failure to Supervise Use of Flash Research Emails That Might Convey Nonpublic Information;
  • No Change to Deadline for FCMs to Top-Up Customer Segregated Accounts Recommended by CFTC Staff;
  • CFTC Proposes to Confirm Electricity Transmission Organizations' Exemption From Most Provisions of Commodity Exchange Act But Will Permit Private Lawsuits; and more.

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Controller of FCM Named in CFTC Complaint, Along with Firm, for Failure to Timely Notify Commission of Segregation Breach:

Cunningham Commodities, LLC, a futures commission merchant registered with the Commodity Futures Trading Commission, and Salvatore Russo, its controller and head accountant, settled CFTC administrative charges for allegedly not immediately notifying the Commission when Mr. Russo recognized the firm’s failure one night to hold (1) its required minimum amount of funds in its segregated customer account and (2) its own targeted amount of its own funds in its customer segregated account as a buffer. The firm's segregated funds inadequacy apparently was caused by a clerical error.

The firm also settled charges related to its alleged failure to file with the Commission required reports of certain open positions for large traders for almost six months on one occasion, and two weeks on another occasion.

The respondents both agreed to pay one fine of US $150,000 to resolve the CFTC’s enforcement action.

According to the CFTC, on March 10, 2014, a staff accountant failed to transfer US $5 million in loaned funds from Cunningham’s house account to its customer segregated account. As a result, the firm incurred a customer segregated funds’ deficiency in excess of US $3.4 million, and failed to maintain the firm’s targeted amounts of its own funds in segregation (US $600,000) in excess of the firm’s minimum customer segregated funds’ requirement. (Under applicable CFTC rules, FCMs are required to maintain a certain minimum calculable amount of funds equaling certain of their obligations to their customers, as well as a certain minimum amount of their own capital – known as their targeted residual interest – in specially designated customer segregated accounts. Click here for an overview of these requirements.)

When Mr. Russo observed this error the next morning, May 11, 2014, he instructed the same staff accountant to have Cunningham’s bank transfer the necessary funds from the house to a customer segregated account “as of” the prior business day. The bank made this transfer. However, on the same day, Mr. Russo did not cause the firm to file notice of its regulatory breach with the CFTC or report this matter to the firm’s chief compliance officer.

On May 11, the Chicago Mercantile Exchange observed this error, apparently through a comparison of the firm’s formal report of customer segregated funds filed with it, and with bank statements of the firm’s customer segregated accounts filed directly with it by depositories holding its customers’ funds.

Cunningham’s CCO was not aware of this matter when contacted by the CME on March 11, 2014. The following day, Cunningham notified the CFTC of its March 10 deficiencies. The CFTC claimed this notice filing was delinquent.

In addition, the CFTC alleged that, from November 27, 2013, to May 14, 2014, and from July 3 to 15, 2014, Cunningham failed to include certain positions in its required reports to the CFTC of positions of its large traders. During the earlier period, the firm excluded silver contract positions, and during the later period failed to include soybean option positions. According to the CFTC, the firm said the reporting problem was attributable to the failure of an outside software vendor to properly set up the relevant contracts for reporting. (Under applicable CFTC rules, FCMs are obligated to daily report to the CFTC positions in excess of certain levels of its large traders – known as reportable positions (click here for an overview of the CFTC’s large trader reporting program)).

The respondents neither admitted nor denied any of the CFTC’s findings or conclusions in agreeing to the settlement.

Compliance Weeds: CFTC Regulation 1.12 requires that FCMs provide notice to the CFTC on a heightened schedule from “immediately” to within two business days, depending on the specific subsection, of certain specified violations of CFTC rules. Immediate notice to the CFTC is required, for example, when an FCM’s adjusted net capital falls below minimum required amounts or when the amount of funds it carries in its customer segregated accounts is less than required by the applicable regulation. (Click here to access CFTC Regulation 1.12; click here to access a convenient chart prepared by the National Futures Association enumerating CFTC’s required notice and other filings.) Any notice required to be filed with the CFTC by an FCM must also be filed with the firm’s designated self-regulatory organization, as well as with the Securities and Exchange Commission if the FCM is also registered with the SEC as a broker-dealer. CFTC Regulation 1.12 also includes some notice filing obligations for introducing brokers and self-regulatory organizations. Every notice filled under CFTC Regulation 1.12 must include a discussion of how the reporting event originated and what steps have been, or are being, taken to fix the reporting event. When regulated entities discover potentially reportable events they should be conscious of the time frames required for reporting and not unnecessarily delay a filing while researching the potential issue. On the other hand, care should be taken to avoid filing information that has to be repeatedly amended.

My View: The CFTC sends a clear message in bringing this enforcement action against both the FCM and its controller that it will name individuals who it believes are responsible for a firm’s wrongdoing, even if seemingly done in good faith. Here, the FCM’s controller saw that a required transfer of funds had not been made when required but fixed the mistake by instructing the firm’s bank to transfer the funds “as of” the time the correct transfer should have been made. However, in the CFTC’s view, a retroactive fix, while a fix, still gave rise to a reportable event. Indeed, in this enforcement action, the firm did not sue respondents because Cunningham breached its customer segregated funds’ requirements, but solely for not immediately reporting the customer segregated funds and residual interest breaches when they were discovered. Fortunately, the CFTC demonstrated wise discretion in not also naming Cunningham’s CCO in this matter.

Briefly:

  • Dubai-Based Trader Barred by DFSA for Hiding Trading Losses of US $11 Million by Mismarking Positions: The Dubai Financial Services Authority barred Noyan Ayhan from engaging in financial services functions in or from the Dubai International Financial Center for allegedly hiding trading losses of approximately US $11 million from his unnamed employer bank. According to DFSA, Mr. Ayhan purportedly hid his losses by mismarking trading positions of his trading desk that included positions in Turkish government bonds and related swaps from April 30 to July 22, 2014. Mr. Ayhan also colluded with brokers at various local Turkish banks to post orders on the last trading day of April, May and June 2014 for trades in Turkish government bonds on the Borsa Istanbul, charged the Dubai regulator. The DFSA claimed that Mr. Ayhan engaged in this activity with other brokers to create closing prices that would match his month-end marks in order to avoid detection by his employer’s Financial Management team which, as of the last day of each month, compared independent price valuations with internal trading books’ month-end marks. According to DFSA, when interviewed by his bank employer, Mr. Ayhan said he “aggressively marked” his bonds but did not engage in mismarking, and did not remember any conversations with brokers regarding month-end trades even after being shown transcripts of conversations. Under DFSA’s bar order, Mr. Ayhan may request a variance or revocation of his work restriction after six years.

Culture and Ethics: Apparently, on June 16, 2014, in the middle of Mr. Ayhan’s ongoing alleged fraud, Mr. Ayhan requested a subordinate to falsely mark the book of his trading desk when he was out of the office one day while on leave. Although the subordinate questioned Mr. Ayhan’s proposed marks, terming them “absurd,” he followed his boss’s instructions when Mr. Ayhan said he would correct them the following day and disclose the “true” profit and loss to management. The next day, Mr. Ayhan returned to work and advised his subordinate that he would not correct the marks or disclose the true P&L to management. Although DFSA's decision notice does not disclose whether the subordinate at that time informed his employer bank’s management of Mr. Ayhan’s behavior, it is alleged that Mr. Ayhan’s purportedly wrongful practices continued for at least one more month. All employees within a company must continuously be reminded of their obligation to report improper, let alone illegal, conduct to designated persons. Reporting wrongful conduct internally (without fear of retaliation) must be imbedded in the culture of each legal entity.

  • Incoming FCA Head Identifies “Hubris Risk” As Among the Risks Banks Can Mitigate Only Through a Strong Culture: Andrew Bailey, the incoming head of the UK Financial Conduct Authority (as of July 1, 2016), expressed his belief that “hubris risk” or the risk of “blinding over-confidence” is among the most dangerous of risks banks confront daily and that it only can be addressed through adoption of a strong culture. In a speech before the City Week 2016 Conference in London, Mr. Bailey noted that there is a correlation between culture and bad outcomes, “for instance where management are so convinced of their rightness that they hurtle for the cliff without questioning the direction of travel.” According to Mr. Bailey, “there has not been a case of major prudential or conduct failing in a firm which did not have among its root causes a failure of culture as manifested in governance, remuneration, risk management or tone from the top.” Mr. Bailey, who currently is deputy governor and chief executive officer of the UK Prudential Regulation Authority, claimed that regulators can’t force a good culture onto banks. However, he applauded the introduction of the new Senior Managers and Certification Regime in the United Kingdom, which he said would make senior managers more personally responsible for the affairs of their firms. Mr. Bailey observed that while there have been major changes in banks’ culture in the past few years, “public opinion does not recognise these developments and tends to think that nothing has changed.” He urged banks to continue their progress in developing positive cultures, which includes ensuring there are “appropriate challenges from all levels of [an] organization.”
     
  • Alleged Spoofer in CFTC Enforcement Action Claims Relevant Statute and Regulation Unconstitutionally Vague: The trader and his company subject to an enforcement action by the Commodity Futures Trading Commission in a federal court in Chicago for alleged spoofing through posting and flipping trading conduct, filed a motion to dismiss the CFTC’s action on the grounds that the law prohibiting spoofing (click here to access 7 USC § 6c(5)) and the CFTC rule prohibiting deceptive contrivances (click here to access CFTC rule 180.1) are constitutionally void for vagueness. (Click here for details regarding this enforcement action in the article, “CFTC Enforcement Action Introduces New Theory of Spoofing” in the October 25, 2015 edition of Bridging the Week.) According to papers filed by the defendants in support of their motion, the CFTC has never provided official notice of what activity might qualify as spoofing or be of “the character of or commonly known to the trade as ‘spoofing.’” Defendants argued that “[t] he CFTC has had five years to try to rectify the vagueness of the Spoofing Statute by issuing a rule or regulation to prohibit trading practices that may constitute spoofing, but it has failed to do so.” Defendants acknowledged that the CFTC issued a guidance and policy statement in May 2013 regarding spoofing (click here to access), but said that document “does not conclude that there is any common understanding in the trade of what constitutes ‘spoofing’ or set forth what that understanding might be.” Just recently, a federal court judge refused to set aside the spoofing conviction of Michael Coscia, declining to find the relevant statute void for vagueness. (Click here for details of this decision in the article, “Federal Court Declines to Set Aside Coscia Spoofing Conviction” in the April 10, 2016 edition of Bridging the Week.)

My View: From the outset, I have had difficulty understanding the meaning of “spoofing” as defined under the Commodity Exchange Act. Although the law expressly defines spoofing in a parenthetical phrase as “bidding or offering with the intent to cancel the bid or offer before execution,” defining an offense – if the definition is wrong or universally regarded as unclear – does not provide the type of fair notice that is necessary to make a law constitutionally valid. When the Financial Industry Regulatory Authority recently issued report cards to member firms to help them detect potential spoofing and layering activity, FINRA defined spoofing as “entering orders to entice other participants to join on the same side of the market at a price at which they would not ordinarily trade, and then trading against the other market participants’ orders” – a very different definition than that in the CEA. (Click here for background on FINRA’s new spoofing report cards in the article, “FINRA Hands Out Report Cards on Potential Spoofing and Layering” in the May 1, 2016 edition of Bridging the Week.) Although the CME Group enacted a provision prohibiting spoofing that parallels the similar CEA provision, it issued an advisory that made clear that the concept of spoofing is muddy at best. For example, a stop order is often placed with the desire that it will never be executed because execution would mean that a position is moving in an adverse direction. However, CME Group distinguished between “intent” and “hope” when saying that stop orders did not violate its prohibition against spoofing in a way that leaves a reasonable person rightfully scratching his or her head:

Market participants may enter stop orders as a means of minimizing potential losses with the hope that the order will not be triggered. However, it must be the intent of the market participant that the order will be executed if the specified condition is met. Such an order is not prohibited [by the applicable CME Group] Rule.

Indeed, if there was any doubt regarding the vagueness of what is prohibited, the Intercontinental Exchange, through three of its exchanges in Europe, Canada and the United States, uses three similar but subtly differently drafted rules to prohibit disruptive trading. (Click here for details of ICE’s different rules in the article, “ICE Futures Europe to Adopt Another Variation of Disruptive Trading Practices Rule” in the January 11, 2015 edition of Bridging the Week.) Even at the same time that Michael Coscia settled with the Commodity Futures Trading Commission in 2013 for prohibited “spoofing,” he settled with the Financial Conduct Authority in the United Kingdom for the identical conduct – but there it was termed “layering” (click here to access a copy of FCA’s Final Notice regarding Mr. Coscia). The CEA provision prohibiting spoofing was badly drafted because it prohibits a named activity that has different meanings to different people rather than banning the purportedly bad conduct itself. There is no one commonly accepted definition of what constitutes spoofing, despite the parenthetical clause in the applicable law. Thus, there is no fair notice of what is prohibited.

  • Broker-Dealer Sanctioned by FINRA for Alleged Failure to Supervise Use of Flash Research Emails That Might Convey Nonpublic Information: The Financial Industry Regulatory Authority brought and settled charges against Stephens Inc., a broker-dealer, for not supervising “flash” emails used by research analysts to advise other firm personnel of developments regarding companies covered by the firm’s research department in advance of public pronouncements. According to FINRA, from at least August 2013 through January 2016, Stephens issued flash emails that might have inadvertently conveyed nonpublic inside information, at a time when such information should not have been disseminated, that could have been used to make trading decisions. Sometimes, charged FINRA, Stephens’ flash emails were forwarded by Stephens’ brokers to public customers or excerpts were provided to them. However, said FINRA, “[t]he firm’s policies and procedures regarding the content of flash emails did not provide … guidance or restrictions beyond stating that research analysts were prohibited from previewing ratings, earnings estimates, and price target changes in emails.” Among other things, FINRA charged that Stephens did not monitor trading that occurred before the formal publication of research reports, but after the issuance of flash emails. To resolve FINRA’s allegations, Stephens agreed to pay a fine of US $900,000 and to implement a comprehensive review of its policies and procedures regarding the dissemination of potentially nonpublic inside information.
     
  • No Change to Deadline for FCMs to Top-Up Customer Segregated Accounts Recommended by CFTC Staff: Staff of the Commodity Futures Trading Commission recommended that there be no change in the current time that futures commission merchants must put their own funds in their customer segregated accounts to cover for the aggregate undermargined amounts of their customers. Under CFTC rules, an FCM is prohibited from using the funds of one customer to satisfy the obligations of another customer. To help avoid this, the CFTC adopted a new rule in 2013 (click here to access CFTC Rule 1.22) that requires an FCM by 6 p.m. on each business day (T+1) to include in its customer segregated accounts an amount of its own capital at least equal to the amount of its customers aggregate margin deficits calculated as of the prior business day (T). Under the rule, as subsequently amended, the CFTC had to consider whether the time of FCMs’ top-up should be accelerated to the time of settlement on T+1 (i.e., before 6 p.m.) or some other time. Commission staff recommended not changing the current requirements following their consideration of comments received during a public roundtable earlier this year and in writing. In these comments, concern was expressed that if the CFTC accelerated the time of FCMs’ required top-up, it would increase costs to FCMs’ clients as FCMs would pass along the cost of utilizing the FCMs’ capital for this purpose. The CFTC will accept comments to the staff’s report through June 13, 2016.
     
  • CFTC Proposes to Confirm Electricity Transmission Organizations' Exemption From Most Provisions of Commodity Exchange Act But Will Permit Private Lawsuits: The Commodity Futures Trading Commission proposed to amend a March 2013 order that exempted certain electric energy transactions from most requirements under the Commodity Exchange Act and CFTC regulations. The order was for the benefit of certain regional transmission organizations ("RTOs") and independent system operators ("ISOs") and was limited to transactions for the purchase and sale of certain enumerated electric energy-related products. The order exempted relevant RTOs and ISOs from all provisions of applicable law and CFTC regulations with the exception of anti-fraud and anti-manipulation requirements, as well as specified scienter-based prohibitions. However, the order was silent on the application of the law’s private right of action authorization (click here to access this provision of law – 7 USC § 25). However in a recent federal appeals court decision, it was held that a private right of action does not exist under the CFTC’s March 2013 Order (click here to access the relevant legal decision). In response, in the proposed amendment, the Commission proposes to make clear that the private right of action provision is applicable. In a vigorous dissent, Commissioner J. Christopher Giancarlo objected to a change of course at this time in the CFTC’s proposed regulation without a change of law or circumstances necessitating such amendment. He said it was “disingenuous” for the CFTC to now claim that its prior silence evidenced its intent “all along” to retain a private right of action. However, in supporting the proposed amendment, Chairman Timothy Massad acknowledged the ambiguity engendered by the Commission’s prior silence, but said that “we should decide the issue now on the merits.” The Commission will accept comments on its proposal for 30 days following its publication in the Federal Register.

And more briefly:

  • IOSCO Cautions on Regulatory Gaps of Storage Infrastructures for Exchange-Traded Physically Delivered Commodity Derivatives: The International Organization of Securities Commissions issued a report on the impact of delivery infrastructures (e.g., warehouses) on market prices involving commodity derivatives. Although IOSCO did not recommend adoption of any additional regulatory measures at this time, it did identify practices “that have the potential to affect derivatives pricing and efficient market operations.” Among other things, IOSCO noted that, although financial regulators generally do not have daily oversight over warehouses, they do have the ability to conduct investigations and enforcement actions related to their “relevant statutory oversight.” However, this gap may cause a delay in addressing emerging problems.
     
  • Inspection Unit Criticizes CFTC’s Renting of Unused Office Space: The Office of Inspector General of the Commodity Futures Trading Commission criticized the agency’s rental of space that it does not use. According to OIG, the CFTC currently spends between $2 and 2.8 million/year on office space it does not use in its DC office, and uses only between 78 and 81 percent of its rented space in its Chicago, Kansas City and New York offices. OIG estimates the CFTC will spend approximately $44.7 – $56.8 million on unused office space in these offices during the life of the relevant leases. In response, the CFTC said it has taken steps to “address issues related to its leasing,” but noted that, in general, it bases its leasing decisions “on its ability to fulfill its statutory mission.”
     
  • ISDA and Other Industry Organizations Adopt International Cybersecurity Core Principles: Three international industry groups, including the International Swaps and Derivatives Association, recommended that key international regulators adopt uniform global policies on cybersecurity, data and technology. Among other principles promoted by the groups were that regulators should recognize that there is no “one-size-fits-all approach” to cybersecurity and that regulations “should enable programs that are risk-based, threat-informed, and based on the size, scope, function and business model of the entity being regulated.” The groups also warned against any requirements to disclose source code, claiming that “[s]uch disclosure would expose firms to unquantifiable financial risk from litigation, and IP actions by software and IP licensors for breach of standard controls and contractual provisions protecting supplier IP.” The other international groups making these recommendations were the Global Financial Markets Association and the European Banking Federation.
     
  • Ontario and Quebec Publish Final Rules to Enhance OTC Swaps Trading Transparency: Both the Autorité des Marchés Financiers of Quebec and the Ontario Securities Commission published final amendments to rules aimed at increasing transparency in the Canadian over-the-counter derivatives markets. The amendments specify which transaction level data is required to be published by trade repositories, the timing of publication and the related asset classes. Data must be made public starting January 16, 2017.

And finally:

  • Trade Secrets Protection: As a result of the new Defend Trade Secrets Act, enacted last week, federal civil protection is now afforded to trade secrets alongside copyrights, patents and trademarks. The new law also imposes certain employer obligations. This is an important development for all firms that have invested in creating trade secrets including, potentially, algorithmic trading systems. Click here to access a special Advisory prepared by Katten Muchin Rosenman LLP on this topic.

For more information, see:

Alleged Spoofer in CFTC Enforcement Action Claims Relevant Statute and Regulation Unconstitutionally Vague:
/ckfinder/userfiles/files/Oystacher%20Motion%20May%202016.pdf

Broker-Dealer Sanctioned by FINRA for Alleged Failure to Supervise Use of Flash Research Emails That Might Convey Nonpublic Information:
http://www.finra.org/sites/default/files/Stephens_AWC_051116.pdf

CFTC Proposes to Confirm Electricity Transmission Organizations' Exemption From Most Provisions of Commodity Exchange Act But Will Permit Private Lawsuits:
http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/federalregister051016.pdf

Controller of FCM Named in CFTC Complaint for Failure to Timely Notify Commission of Segregation Breach:
http://www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfcunninghamorder050916.pdf

Dubai-Based Trader Barred by DFSA for Hiding Trading Losses of US $11 Million by Mismarking Positions:
http://dfsa.ae/Documents/Regulatory-Actions-2016/001_NA_Decision_Notice_300316.pdf

Incoming FCA Head Identifies “Hubris Risk” As Among the Risks Banks Can Mitigate Only Through a Strong Culture:
http://www.bankofengland.co.uk/publications/Documents/speeches/2016/speech901.pdf

Inspection Unit Criticizes CFTC’s Renting of Unused Office Space:
http://www.cftc.gov/idc/groups/public/@aboutcftc/documents/file/oig_rdc042516.pdf

IOSCO Cautions on Regulatory Gaps Storage of Infrastructures for Exchange-Traded Physically Delivered Commodity Derivatives:
http://www.iosco.org/library/pubdocs/pdf/IOSCOPD530.pdf

ISDA and Other Industry Organizations Adopt International Cybersecurity Core Principles:
http://www.gfma.org/correspondence/item.aspx?id=807

No Change to Deadline for FCMs to Top-Up Customer Segregated Accounts Recommended by CFTC Staff:
http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/residualinterestreport050616.pdf

Ontario and Quebec Publish Final Rules to Enhance OTC Swaps Trading Transparency:

Ontario:
http://www.osc.gov.on.ca/en/SecuritiesLaw_rule_20160512_91-507_derivatives-data-reporting.htm
Quebec:
https://www.lautorite.qc.ca/en/pending-ministerial-derivatives-pro.html

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of May 14, 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.


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