Bridging the Week by Gary DeWaal

Bridging the Weeks by Gary DeWaal: May 20 – June 7, and June 10, 2019 (O Canada ICO!, Disruptive Trading, New Supervisory Rules; Whose Best Interest?)

Bitcoin Ecosystem    Block Trades and EFRPs    Books and Records    Bridging the Week    Compliance Weeds    Cryptosecurities    Culture and Ethics    Customer Protection    Cybersecurity    Forum Selection    Introducing Brokers    Investment Advisers    Legal Weeds    Managed Money    Manipulation    Memory Lane    My View    Policy and Politics    Regulation Best Interest    Supervision    Trade Practices (including Disruptive Trading)    Uncleared Swaps   
Published Date: June 09, 2019

Last week, a Canada-based social media company was sued by the Securities and Exchange Commission for purportedly conducting an unregistered securities offering to United States persons in connection with an initial coin offering of digital tokens. The firm previously asserted in a so-called Wells submission to the SEC that its cryptoassets were not securities, but in any case, purchasers in its ICO would not have expected profits through the efforts of the firm and its agents, but rather solely through secondary market transactions. Separately, in recent prior weeks, the Chicago Mercantile Exchange brought a disciplinary action against a member for liquidating large positions in post-trade settlement periods without considering the impact of the orders on market prices, while the National Futures Association proposed a major overhaul of its guidance on branch office and guaranteed-introducing broker oversight. As a result, the following matters are covered in this week’s edition of Bridging the Weeks:

  • SEC Kicks Canada-Based ICO Issuer; Claims It Conducted Unregistered Securities Offering to US Persons (includes My View); 
  • CME Sanctions Trader for Liquidating Large Positions Without Considering Market Impact (includes Compliance Weeds); 
  • SEC Adopts New Regulation to Ensure Retail Customers’ Best Interest Takes Priority Over Broker-Dealer’s (includes Memory Lane: why the futures industry has no suitability rule);
  • NFA Proposes Overhaul of Requirements for Supervision of Branch Offices and Guaranteed IBs (includes Compliance Weeds);
  • Misusing Client Block Trades’ Information and Phone Recording Breakdown Result in NFA Sanctions Against Multiple Parties (includes Legal Weeds); and more.

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Briefly:

  • SEC Kicks Canada-Based ICO Issuer; Claims It Conducted Unregistered Securities Offering to US Persons: The Securities and Exchange Commission filed a lawsuit against Kik Interactive Inc., claiming that, from May through September 2017, the firm conducted an initial coin offering of one trillion Kin digital tokens without registering the cryptoassets with the SEC as required by law. According to the SEC, investors who purchased Kin tokens made an investment of money in a common enterprise with Kik and with other investors, and reasonably expected profits through the business and management activities of Kik and its agents.

Kik is an Ontario, Canada-based company that developed and promotes a popular internet chat messaging service.

In its complaint filed in a federal court in New York City, the SEC alleged that Kik determined in late 2016 through early 2017 to raise funds through an ICO when it recognized that the popularity of its chat service was declining, and it would run out of cash to fund its operations by late 2017. The firm decided to embark on a new business strategy, involving the development of the “Kin ecosystem” wherein persons could use Kin tokens to purchase goods and services. One director of Kik, termed this “pivot” to a new business model a “hail Mary pass,” claimed the SEC. 

However, said the Commission, at the time of the ICO, the Kin ecosystem, as contemplated, did not exist, and proceeds from the ICO were intended to fund its development. According to the SEC, Kik extensively promoted the ICO as an investment opportunity.

Just prior to the launch of the ICO, the SEC published its so-called “DAO report” on July 25, 2017, in which it said that digital tokens might be securities under US law. (Click here for background in the article,” SEC Declines to Prosecute Issuer of Digital Tokens That It Deems Securities Not Issued in Accordance with US Securities Laws” in the July 26, 2017 edition of Between Bridges.) In response, Kik contacted the Ontario Securities Commission to determine the legality of its offering in Canada. After being advised by OSC that its proposed offer of Kin would constitute the offering of securities, Kik determined to bar Canadians from purchasing Kin in its public sale. The firm did not similarly reach out to the SEC, said the Commission.

The Commission calculated that, through its ICO, as well as a pre-offering (known as a simple agreement for future tokens or “SAFT”) to certain professional investment funds and wealthy investors, Kik raised almost US $100 million, including more than US $55 million from US investors.

The SEC seeks to prohibit Kik from violating US securities law registration requirements, to disgorge funds raised through its ICO and to pay a fine. The agency requested a jury trial for this matter.

Previously, Kik publicized the possibility that it might be sued by the SEC in connection with its Kin ICO. In a so-called “Wells Submission” to the SEC, Kik claimed that Kin was a virtual currency and not subject to US securities laws, and in any case, there was no common enterprise between Kik on the one hand and purchasers of Kin on the other, and no expectation by any Kin purchaser of profits because of the managerial or entrepreneurial efforts of Kik. (Click here for details in the Legal Weeds section of the article, “California Federal Court Reverses Itself and Grants SEC Preliminary Injunction in Purported Cryptoasset Scam” in the February 17, 2019 edition of Bridging the Week.) 

In response to the SEC’s complaint, Kik released a statement in which it said, “We have been expecting this for quite some time, and we welcome the opportunity to fight for the future of crypto in the United States. We hope this case will make it clear that the securities laws should not be applied to a currency used by millions of people in dozens of apps." (Click here to access the full Kik statement.) Recently, Kik launched an initiative called “Defend Crypto” to raise US $5 million to help defend itself in the SEC action through voluntary contributions; through June 7, the firm claimed it had received US $4.4 million. (click here for details).

In other legal and regulatory developments regarding cryptoassets:

  • IOSCO Solicits Feedback on Proposed Key Considerations for Regulators’ Evaluation of Cryptoasset Trading Platforms: The International Organization of Securities Commissions issued a consultation report to help regulatory authorities evaluate cryptoasset trading platforms ("CTPs") under their oversight. Although CTPs often perform functions similar to trading venues, IOSCO noted that the platforms also “perform functions that are more typically performed by intermediaries, custodians, transfer agents and clearing houses.” As a result, key matters IOSCO recommends regulatory authorities consider when contemplating CTPs include: (1) how is access provided, and if non-intermediated, who is responsible for on-boarding and how is it performed; (2) how are customer assets held and protected; (3) where customer assets are held, what financial resources exist to protect against bankruptcy or insolvency; (4) what conflicts of interest exist and how are they managed; (5) what information exists regarding a CTP’s operations; (6) what rules and protections exist against market abuse; (7) how efficient is price discovery; (8) how resilient and reliable are critical systems; (9) and how is cybersecurity assured. IOSCO will accept comments to its consultation through July 29, 2019.
     
  • European Central Bank Says Risks of Cryptoassets Minimal on Monetary Policy, Payments and Market Infrastructures: The European Central Bank published findings of a cryptoasset task force it established in March 2018 to consider the impact of digital assets on monetary policy and the risks they may pose to “the smooth functioning of market infrastructures and payments, as well as for the stability of the financial system.”  Currently, said the ECB, while cryptoassets do not impose an “immediate threat” to financial stability, they pose risks regarding money laundering/terrorist financing and consumer protection. Digital assets are unusual, noted the ECB, because they have no underlying fundamental value – they do not “represent either a financial claim on, or a financial liability of, any natural or legal person, and [do] not embody a proprietary right against an entity.” The task force recommended that the ECB continue to monitor “the cryptoasset phenomenon” and be prepared for any “adverse scenarios.”
  • Final Decision on Bitcoin ETF Again Delayed by SEC: The SEC delayed its evaluation of a proposed rule change by the Cboe BZX Exchange to permit listing and trading of shares of SolidX Bitcoin Shares issued by the VanEck SolidX Bitcoin Trust in order to undertake further analysis. Cboe initially filed its proposed rule change on January 30, 2019 and the SEC designated May 21, 2019 as the day by which it would approve, disapprove or begin proceedings to determine how to go forward. The SEC extended this period on March 29. The SEC has now initiated proceedings to make a final determination. The Commission will accept comments regarding Cboe’s proposal through 21 days after its publication in the Federal Register, and rebuttal comments for 35 days after such publication.
     
  • ASIC Issues Advisory on ICOs and Cryptoasset Trading Platforms: The Australian Securities & Investment Commission published an overview of regulatory considerations related to ICOs and cryptoassets. Among other things, ASIC noted that, under Australian law, significant regulatory requirements may apply to the issuance of cryptoassets that fall within the definition of a financial product (e.g., securities, derivatives, general and life insurance, superannuation, margin lending, carbon units, deposit accounts and means of payment facilities). Among other things, licensing or authorization requirements may apply to cryptoasset intermediaries, exchanges and trading platforms, as well as wallet and custody service providers. Under Australia law, there are prohibitions against misleading or deceptive conduct for both ICOs and cryptoassets that involve and do not involve financial products.

My View:Two months ago, the SEC’s Strategic Hub for Innovation and Financial Technology issued guidance on what characteristics a cryptoasset might have that could make it more likely to be deemed an investment contract, and thus a security, under US securities laws. FinHub noted that these characteristics pertain not solely to the “form and terms” of the digital asset itself, but also “the means in which it is offered, sold or resold (which includes secondary market sales).”

In providing its analysis, FinHub utilized the three prongs of the Howey test to determine if an instrument was an investment contract (i.e., an (1) investment of money (2) in a common enterprise with the (3) reasonable expectation of profits through efforts of others), and keyed in on the last prong. (Click here to access the Supreme Court’s 1946 decision in SEC v. W.J. Howey.)

(Click here for background on the FinHub’s guidance in the article “SEC Staff Outlines Characteristics of Cryptoassets That Could Cause Them to Be Regarded as Securities” in the April 7, 2019 edition of Bridging the Week.)

In its complaint against Kik, the SEC tracked many of the themes in its April 2019 guidance in explaining why the Kin ICO constituted an offer of securities. The Commission meticulously laid out the basis for its view that investors who participated in the Kin ICO were investing money in a common enterprise and did so because they believed they would profit through the appreciation in the price of Kin as a result of the efforts of Kik and its agents in developing the Kin ecosystem and promoting Kin. 

Internally at Kik, said the SEC, employees were told how the Kin ICO would be a “new way” to raise capital. Externally, noted the SEC, Kik and its agents emphasized to prospective Kin purchasers the opportunity to profit alongside other Kin investors as well as Kik itself as the Kin ecosystem was developed and matured. Critically, at the time of the ICO, said the SEC, the sole feature of the Kin ecosystem was a minimum value product in the form of cartoon stickers that was intended to enhance the Kik Messenger experience. Proceeds from the ICO were intended to fund the Kin ecosystem development.

Although Kik has not yet formally answered the SEC’s complaint, it previewed its response in a Wells Submission filed with the SEC last December as well as in a formal statement issued after the Commission’s filing.  Generally, Kik believes the SEC has stretched Howey too broadly, but in any case, Kin is not a security; purchasers did not invest funds in a common enterprise; and purchasers did not have a reasonable expectation of profits through the efforts of Kik and its agents. Profits per Kik were to be obtained through ordinary market forces.

Notwithstanding Kik’s apparent arguments, if the SEC can prove the facts it pleaded, Kik will have an uphill battle. Howey – like it or not – is a long established Supreme Court precedent and it will be very challenging for Kik to convince a jury that what looks like a security offering, walks like a security offering and sounds like a security offering was anything else but a security offering. 

That being said, it is not beyond possibility that a court could hold that a financial instrument that conveys no rights, directly or indirectly, to income from a corporation and where a holder has no claims of any kind if the corporation files for bankruptcy is not a security. Kik’s argument that any profits achieved through ordinary secondary market trading would not have been attributable to Kik or its agents has some technical, intellectual appeal; however, it likely ignores the impact of the firm’s alleged purposeful publicity on market sentiment.

  • CME Sanctions Trader for Liquidating Large Positions Without Considering Market Impact: Cody Easterday agreed to settle a disciplinary action brought by the Chicago Mercantile Exchange, claiming that on multiple occasions from July 5 through August 2, 2017, he liquidated large positions in Live Cattle and Feeder Cattle futures contracts that resulted in “significant and disruptive price movements.” Specifically, claimed CME, Mr. Easterday entered orders during the post-settlement trading period to offset positions he put on during regular trading hours. He did this, charged CME, “with reckless disregard for the adverse impact on the orderly conduct of trading. According to CME, Mr. Easterday should have been aware of the potential impact of his orders on market prices because his order quantity was greater than the five visible levels of the order book during the post-settlement trading period. Mr. Easterday, a CME member, resolved his CME disciplinary action by agreeing to pay a fine of US $30,000 and having his trading access to all CME Group exchanges suspended for 20 business days. 

    Unrelatedly,  AWH Financial LLC was ordered to pay a fine of US $25,000 and disgorgement of US $53,562 by a panel of the Business Conduct Committee of the Chicago Board of Trade for violating spot month position limits in corn futures on August 30, 2017. CBOT alleged that he violated the 600 lot spot month position limit by 600 lots or 100 percent. AWH did not dispute the facts of the CBOT’s allegations; instead a hearing was held solely to assess the amount of AWH’s fine. Although the panel found that AWH lost money on its overall spot month position, it held that “AWH benefited from the position limit violation by avoiding additional losses it would have incurred had it not violated the rule.”

Separately, Jonathan Alexander, a former trader for Macquarie Energy LLC, agreed to pay a fine of US $85,000 to ICE Futures U.S. and incur a nine-month trading suspension on all IFUS markets for possibly engaging in manipulative and disruptive practices to cause market participants to trade at artificial prices. According to IFUS, on various days between August 5 and 18, 2016, Mr. Alexander entered offers in the ERCOT North 345 KV Real-Time Off-PeakDaily Fixed Price futures contract at prices more consistent with the historical prices of the ERCOT North 345 KV Real-Time Peak Daily Fixed Price futures contract. 

As a result of the manner in which Mr. Alexander placed  his offers, some market participants believed there were favorable buying opportunities in the Peak futures and that they were purchasing Peak futures contracts. However, in fact, the market participants were transacting in the Off-Peak futures and subsequently reported the trades as an error and received substantial adjustments. According to IFUS, Mr. Alexander engaged in this behavior “after he unknowingly fell victim to the same circumstances he then caused to occur. [He] intended to provide the point that he was dissatisfied with the price adjustment [he received from IFUS] after executing a series of trades in a wrong market.” Macquarie Energy also agreed to pay a fine of US $250,000 to resolve IFUS charges related to Mr. Alexander’s conduct.

Compliance Weeds: It’s not just spoofing that might constitute disruptive trading.

In March 2017, Saxo Bank A/S, a member firm, agreed to pay an aggregate fine of US $190,000 to the CBOT and the CME 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. This appears to be particularly the case where the same person or entity places similar type orders with similar deleterious impact on the market over multiple days.

  • SEC Adopts New Regulation to Ensure Retail Customers’ Best Interest Takes Priority Over Broker-Dealer’s: The Securities and Exchange Commission enacted a new regulation – Regulation Best Interest – to help ensure that broker-dealers and their salespersons act in the best interest of their retail customers when making recommendations for any securities transaction or investment strategy. Additionally, going forward, broker-dealers and investment advisors will be required to provide to retail investors at the beginning of their relationship information in a standardized format (Form CRS “Relationship Summary”) regarding their services, fee and costs, conflicts of interest, legal standards of conduct, and whether they or their financial professionals have disciplinary history. The SEC also issued interpretations regarding the fiduciary duty investment advisors owe their clients, and when advisory services are solely “incidental” to a broker-dealer’s business so as not to require it to register as an investment advisor.

Under Regulation Best Interest, a broker, dealer or natural person associated with a broker or dealer who makes a recommendation to a retail customer of any securities transaction or investment strategy involving securities must act in the best interest of the customer ahead of  the financial or other interests of the broker, dealer or AP. To satisfy this requirement, broker-dealers must satisfy certain enumerated disclosure, care, conflict of interest and compliance obligations.

Commissioner Robert Jackson dissented from the SEC’s vote to pass Regulation Best Interest, saying that “[r]ather than requiring Wall Street to put investors first, today’s rules retain a muddled standard that exposes millions of Americans to the costs of conflicted advice.” Chairman Jay Clayton on the other hand praised the new SEC initiatives, noting that Regulation Best Interest “goes significantly beyond existing broker-dealer obligations”; the Relationship Summary is an “improvement” over existing disclosures; and the fiduciary duty interpretation does not weaken existing standards; instead it “reflects how the Commission and its staff have applied and enforced the law in this area, and inspected for compliance for decades.”

By June 30, 2020, broker-dealers must begin complying with Regulation Best Interest and broker-dealers and investment advisors must prepare and deliver to retail investors Relationship Summaries. The new interpretations will be effective upon publication in the Federal Register.

Memory Lane: Unlike in the securities industry, there are generally no suitability requirements in the futures industry and there is no insurance on customer accounts.

Early in its history, the Commodity Futures Trading Commission considered adoption of a suitability rule – CFTC proposed rule 166.2. Under the proposed rule, Commission registrants would not have been permitted to make a recommendation to buy or sell a futures contract or to engage in a discretionary trade for any customer “unless the registrant had reason to believe the recommendation or trade was suitable for the customer in light of his financial condition.” The Commission declined to adopt proposed rule 166.2 “because the Commission was unable …to formulate meaningful standards or universal application.” (Click here for further background in the 1978 Federal Register discussion regarding the CFTC’s adoption of Part 166 customer protection rules at pg. 31888.)

In 1986, the National Futures Association also declined to adopt a suitability rule for future commission merchants and instead mandated they issue risk disclosure statements to customers and obtain certain information from them (click here to access NFA Rule 2-30). According to NFA, “futures contracts in general are recognized as highly volatile instruments. It therefore makes little sense to presume that a certain futures trade may be appropriate for a customer while others are not. [As a result,] the customer is in the best interest to determine the suitability of futures trading if the customer receives an understandable disclosure of risks from a futures professional who ‘knows the customer’.” (Click here for further background in NFA Interpretive Notice 9004.)

In 2009, the Financial Industry Regulatory Authority proposed extending suitability requirements of broker-dealers for securities to recommendations for all financial products, including futures for combined broker-dealers/FCMs. In addition to arguing against the proposal on the grounds of CFTC preemption, the Futures Industry Association railed against FINRA’s proposal on the grounds that “there is a definitive difference in the various types of products overseen by the SEC and those overseen by the CFTC. Securities and futures products differ in that, while there may be an endless variation of different types of securities with varying investment strategies… futures contracts are inherently standardized with only two traditional types of investors – hedgers and speculators – each of whom trade futures with the investment strategy of risk management and capital gains.” FINRA’s proposal was not adopted. (Click here to review FIA’s June 29, 2009 letter to FINRA re: “Proposed Consolidated FINRA Rules Governing Suitability and Know-Your-Customer Obligations.”)

Notwithstanding, FCMs that are not members of FINRA must ensure that recommendations to customers to buy or sell securities futures or to engage in a trading strategy regarding such products are “not unsuitable” (see NFA Rule 2-30(j)(4)).

Separately, in 2013, CME Group, the FIA, the Institute for Financial Markets and NFA commissioned a study by Compass Lexecon regarding the feasibility of adopting an insurance regime for the US futures industry. Among other alternatives, a model was considered that would offer “the same kind of protection” that at the time was provided to securities investors by the Securities Investor Protection Corporation – up to US $250,000 to every customer of every US FCM to cover losses from the failure of under-segregated FCMs. Under the proposal, the insurance would be funded by FCMs paying 0.5 percent of their annual gross revenue up to a targeted funding level of US $2.5 billion. The study concluded, however, that the proposal was not feasible as it would take 55 years to reach the targeted level, assuming no interim losses. (Click here to access the futures industry-commissioned insurance study.)

  • NFA Proposes Overhaul of Requirements For Supervision of Branch Offices and Guaranteed IBs: The National Futures Association proposed updated guidance related to the supervision of branch offices by all members and relationships with guaranteed introducing brokers. Among other things, under NFA’s proposal, member firms must adopt written policies and procedures that (1) are designed to ensure that a formal due diligence review is undertaken before they establish a branch office or G-IB relationship and (2) set forth the manner in which they will exercise oversight of such entities. Although NFA’s guidance endeavors to provide members with flexibility in designing their specific supervisory programs in light of differences in “the size and complexity of Member firm operations,” the guidance sets forth minimum standards for all members.

For advance due diligence review of potential branches and G-IBs, members will be required to consider the nature of the business to be conducted in the location and the background and employment history of all personnel to ensure they are qualified,  as well as to ensure that at least one person will be able to track Commodity Futures Trading Commission and NFA regulatory developments. As a result of its due diligence, the member should confirm that it wants to establish the branch office or G-IB relationship and determine the scope of the supervisory oversight it should apply on an ongoing basis.

For ongoing supervision, members must implement both routine supervision and surveillance to identify and deal with potential issues as they arise and annual inspections that are meant to be more comprehensive and detailed. A firm’s policies and procedures must expressly note when it will notify NFA and/or other “appropriate regulators” of “significant findings” including, but not limited to, fraud or customer harm. Qualified personnel must perform the routine surveillance and inspections, although third-party vendors may be retained to assist in such activities; however, in such instance the member must perform due diligence to confirm the third-party vendor is qualified. Supervisory procedures for branches and G-IBs must address registration, hiring, promotional material, sales practices, customer information and risk disclosure anti-money laundering, handling of customer funds, customer order procedures, account activity, discretionary accounts, proprietary accounts, bunched orders, customer complaints and information system security programs. As before, members must train their personnel regarding applicable industry rules and regulations and ensure they satisfy ethics requirements. (Click here to access NFA Interpretive Notice 9051.)

The proposed NFA guidance replaces guidance currently associated with NFA Rule 2-9 (click here to access existing NFA Interpretive Notice 9019). NFA submitted its proposed rule change to the CFTC on May 21 subject to a 10-day review schedule. Typically, however, NFA requires compliance with new rules only after a reasonable time which is preceded by member outreach and education.

Compliance Weeds: Importantly, NFA’s revised guidance, like its existing guidance regarding supervision of branch offices and G-IBs, applies to all members – although provisions related to G-IBs are solely meaningful to FCMs and Forex Dealer Members. Accordingly all members must review the revised guidance to assess which provisions might apply to them and to revise their policies and procedures to reflect new requirements. Moreover, all members should be aware of NFA’s expectation that they will escalate to it “and/or” other regulators “significant findings” identified during routine supervision or annual inspections. These might include findings related to fraud or customer harm, but are not expressly limited. When revising their policies and procedures, members should not solely cut and paste NFA’s requirements, but adapt them specifically to their own business operations. Moreover, all policies and procedures should be periodically reviewed and updated to reflect amended regulatory requirements and changed business operations.

  • Misusing Client Block Trades’ Information and Phone Recording Breakdown Result in NFA Sanctions Against Multiple Parties: Classic Energy LLC, an introducing broker registered with the Commodity Futures Trading Commission and a member of the National Futures Association; Mathew Webb, the firm’s president and managing member; and Mary Webb, Mr. Webb’s wife and former chief compliance officer, resolved charges brought by NFA related to alleged illicit block trading by Mr. Webb between May and September 2015, and a breakdown in the firm’s telephone recording system from December 2013 through August 27, 2015.

According to NFA, during the relevant  time, Mr. Webb engaged in at least 13 block trades for customers of Classic where, after confirming an agreed block transaction at a specific price, Mr. Webb entered into the precise futures trade at a better price for a company he owned, MDW Capital LLC. Without the customer’s permission, Mr. Webb subsequently entered into the agreed block trade between MDW on one side, and the customer on the other side, and liquidated the offsetting futures positions at MDW for a profit. NFA reviewed other trading records of MDW and believed Mr. Webb’s illicit activity occurred beyond the May through September 2015 time period.

Separately, from January 2012 through August 27, 2015, Classic had a malfunction in its telephone taping system that precluded recordings. Pursuant to CFTC rules, however, since December 2013, the firm was required to record all oral communications made or received that led to a commodity interest transaction and to retain such recordings for one year (click here to access CFTC Rule 1.35(a)(1)(iii)). According to NFA, Ms. Webb claimed she learned of Classic’s tape-recording breakdown on August 18, 2015 when ICE Futures U.S. made a request for specific telephone conversations during a parallel investigation. However, NFA said that, pursuant to email it reviewed, Ms. Webb and Classic were aware of the telephone recording breakdown since at least February 2015. Ms. Webb never advised NFA of this problem during pre-NFA exam discussions in August and September 2015 or after fieldwork commenced at Classic in connection with an NFA examination on October 12, 2015.

Classic agreed to pay a fine of US $200,000 to resolve NFA’s complaint, while Mr. Webb agreed to be suspended from NFA associate membership through January 3, 2022 in accordance with the terms of an unpublished side letter.  Classic and Ms. Webb agreed to adopt and implement recommendations also made in the unpublished side letter.

Legal Weeds: A mystery solved!

In December 2016, four respondents in IFUS-linked disciplinary actions – Classic, MDW, Mr. Webb, and Lee Tippett, a co-worker of Mr. Webb's – agreed to settle their exchange matters by paying sanctions in excess of $1.15 million; however, from the published decisions, it was unclear precisely what was the possible overall wrongful conduct that gave rise to the sanctions. As a result of publication of the NFA proceeding, this unclarity is no more.

In the IFUS disciplinary action associated with the largest monetary sanction, Mr. Webb agreed to pay a fine of US $503,627 and disgorge profits of US $303,627, as well as incur a five-year trading ban on IFUS for possibly engaging in 52 fictitious transactions and permitting his electronic trading system ID to be used by Mr. Tippett. 

The exchange also charged Mr. Webb with possibly committing or attempting to commit an unspecified fraudulent action on the exchange. In addition, Mr. Tippett agreed to pay a fine of US $100,000 and serve a nine-month exchange trading ban for possibly executing 25 fictitious transactions and using Mr. Webb’s exchange trading system identification. 

In addition, MDW agreed to be permanently barred from all trading on IFUS for possibly engaging in practices “inconsistent with just and equitable principles of trade and conduct detrimental to the best interests of the Exchange,” while Classic Energy LLC consented to paying a fine of US $250,000 and adding compliance staff. (Click here for further details regarding the IFUS disciplinary actions in the article “Defendants in Linked ICE Future U.S. Disciplinary Actions Agree to Pay Collective Sanctions in Excess of US $1.15 Million to Resolve Diverse Charges” in the December 18, 2016 edition of Bridging the Week.) 

More Briefly:

  • FCM Prevails in Federal Court to Have Customer Dispute Heard Before NFA, Not FINRA Arbitration Forum: INTL FCStone Financial Inc., a Commodity Futures Trading Commission-registered futures commission merchant, prevailed in a motion before a US federal court in Chicago to dismiss customer arbitration proceedings that had begun against it at the Financial Industry Regulatory Authority and to compel use of the National Futures Association as the arbitration forum.

At the time of account opening, all defendants except two had signed an agreement with FCStone whereby they agreed that all claims relating to their account would be settled by arbitration before the NFA or at the contract market where the disputed transaction was executed or could have been executed. Notwithstanding, after defendants sustained significant losses in their accounts trading futures in November 2018 they initiated an arbitration against the FCM before FINRA. The defendants argued that because FCStone was a combined FCM and broker-dealer as well as a member of FINRA, it was subject to a FINRA rule that requires members to arbitrate disputes between customers and themselves before FINRA. (Click here to access FINRA Rule 12200.)  FCStone argued that defendants were not customers for purpose of this rule. “Customers,” claimed FCStone meant customers trading securities regulated by the Securities and Exchange Commission, and not commodity-related financial products under the oversight of the Commodity Futures Trading Commission. The court agreed with this view and ordered all defendants except two persons (who did not sign an arbitration agreement with FCStone) to submit their arbitration before NFA.

  • SEC OCIE Summarizes Observed Best Practices for Storage of Customers’ Electronic Records by Broker-Dealers and Investment Advisors: The Securities and Exchange Commission’s Office of Compliance Inspections and Examinations issued an advisory setting forth security risks it has observed with broker-dealers’ and investment advisors’ storage of electronic customer records and information using network storage solutions, including cloud-based systems. Among other things, OCIE observed that some firms did not adequately set security settings on their network solutions to protect against unauthorized access and/or configure settings in accordance with firm standards. Moreover, some firms’ policies and procedures did not reflect the different type of electronic data stored by the firm and the appropriate controls for each type of data.

OCIE indicated that a “configuration management program that includes policies and procedures governing data classification, vendor oversight, and security features will help to mitigate the risks incurred when implementing on-premise or cloud-based network storage solutions.” Among other things, OCIE noted good practices it has observed included adoption of policies and procedures governing installation, ongoing maintenance and regular review of network storage solutions; guidelines for security controls and minimum configuration standards; and vendor management policies and procedures that require, among other things, regular installation of software patches and hardware updates.

  • FSB and IOSCO Express Concerns About Growing International Market Fragmentation: Both the Financial Stability Board and the International Organization of Security Administrators issued papers on international market fragmentation. Both organizations noted that while international cooperation and coordinated action by financial authorities have strengthened oversight of markets since the 2008 financial crisis, “there are signs of fragmentation in certain parts of the financial markets, which may undermine the effectiveness of the G20 reforms.” Both reports expressly identified the trading and clearing of over-the-counter derivatives as an area where market fragmentation has been most prevalent. Future developments, including Brexit, the handling of certain benchmarks, and the potential in the European Union to not recognize foreign oversight of central counter party clearinghouses, could exacerbate this fragmentation suggested the IOSCO report. According to both regulators, this fragmentation has arisen in part because of differences in national regulations and the supervisory practices of financial activities that are international in nature. Both organizations recommended means to help mitigate market fragmentation, including enhancing regulatory and supervisory cooperation (including information sharing) without changing legislative requirements or frameworks. Both organizations also encouraged increased deference to foreign regulators, where possible.
  • CFTC’s Inspection Unit Finds Security Weaknesses in Agency’s Surveillance System Containing Confidential Market and Privacy Information: The Commodity Futures Trading Commission’s Office of the Inspector General issued a report finding security weakness in the Commission’s Integrated Surveillance System used to support the agency’s market surveillance, market research, public reports and other mission critical activities. According to the report, ISS “does not comply with federal …requirements for securing federal systems.” OIG noted this weakness was particularly problematic because of ISS’s inclusion of confidential market and privacy information that could be compromised. Among other recommendations, OIG urged the CFTC to review the security risks of ISS and other legacy applications to ensure they conform to current federal security standards. The CFTC concurred with OIG’s assessment and committed to comply with applicable federal security standards “subject to resource constraints.” In 2017, the Securities and Exchange Commission disclosed that its  Electronic Data Gathering, Analysis and Retrieval system was hacked during 2016, and that persons may have profited from trading on unauthorized information obtained through such intrusion. (Click here for background in the article “SEC Chairman Explains EDGAR Cyber Attack to Senate Committee; Says CAT Rollout Will Not Be Delayed” in the October 1, 2017 edition of Bridging the Week.)

Follow-Up:

  • New CFTC Chairman Confirmed by Senate: Heath Tarbert was officially confirmed on June 5 by the US Senate as the next chairman of the Commodity Futures Trading Commission. In response, the current chairman, J. Christopher Giancarlo, said he would step down from his position on July 15 to be succeeded by Dr. Tarbert.
  • Where’s the CFTC v. Agricultural Food Giants’ Purported Manipulation Settlement?: Previously it was disclosed that Kraft Foods Group, Inc. and Mondelez Global LLC entered into a “binding agreement” with the Commodity Futures Trading Commission to settle the CFTC’s 2015 lawsuit against them which claimed that wheat futures trades the defendants entered into during November 2011 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. (Click here for background in the article “Food Giants Settle CFTC Enforcement Action Alleging Traditional and New Fraud-Based Manipulation” in the March 31, 2019 edition of Bridging the Week.) At the time, the US federal court in Chicago hearing this matter ordered a status update on the settlement on May 28. The status meeting apparently was held but the transcript of the meeting was not made public; another status meeting was ordered for July 30, 2019.
     
  • LME Follows IFUS Lead With Futures Trading Speed Bumps: Last month, the Commodity Futures Trading Commission declined to preclude ICE Futures U.S. from adopting a rule amendment authorizing it to implement speed bumps on certain orders entered in two futures contracts traded on the exchange. (Click here for background in the article “CFTC Staff Declines to Halt Rollout of ICE Futures U.S. Speed Bumps; Two Commissioners Raise Concerns” in the May 19, 2016 edition of Bridging the Week.) On May 30, the London Metal Exchange also announced approval by the UK Financial Conduct Authority for its proposed implementation of speed bumps on its LMEprecious metal markets.  According to LME its speed bumps – which only will apply to contracts traded on LMEprecious – are meant to encourage persons in less liquid markets to place passive orders in order to enhance liquidity and deepen the order book. Under LME’s proposal, all new orders will be subject to an eight millisecond delay. LME speed bumps are expected to be introduced sometime during Q3 2019 and will be subject to a 12-month trial period.

For further information: 

ASIC Issues Advisory on ICOs and Cryptoasset Trading Platforms:
https://asic.gov.au/regulatory-resources/digital-transformation/initial-coin-offerings-and-crypto-assets/

CFTC’s Inspection Unit Finds Security Weaknesses in Agency’s Surveillance System Containing Confidential Market and Privacy Information:
https://www.cftc.gov/media/2076/OIG_CFTCDataGovernanceISS/download

CME Sanctions Trader for Liquidating Large Positions Without Considering Market Impact:

CME:

IFUS:

European Central Bank Says Risks of Cryptoassets Minimal on Monetary Policy, Payments and Market Infrastructures:
https://www.ecb.europa.eu/pub/pdf/scpops/ecb.op223~3ce14e986c.en.pdf

FCM Prevails in Federal Court to Have Customer Dispute Heard Before NFA, Not FINRA Arbitration Forum:
/ckfinder/userfiles/files/Intl%20FCStone.pdf

Final Decision on Bitcoin ETF Again Delayed by SEC:
https://cdn.crowdfundinsider.com/wp-content/uploads/2019/05/SEC-CBOE-VanEck-SolidX-Bitcoin-Trust-5.2.0.1934-85896.pdf

FSB and IOSCO Express Concerns About Growing International Market Fragmentation:

IOSCO Solicits Feedback on Proposed Key Considerations for Regulators’ Evaluation of Cryptoasset Trading Platforms:
https://www.iosco.org/news/pdf/IOSCONEWS530.pdf

LME Follows IFUS Lead With Futures Trading Speed Bumps:
19 165 Technical change to LMEselect FIX message processing for the LMEprecious market (69.36 KB)

Misusing Client Block Trades’ Information and Phone Recording Breakdown Result in NFA Sanctions Against Multiple Parties:

New CFTC Chairman Confirmed by Senate:
https://www.congress.gov/nomination/116th-congress/18

NFA Proposes Overhaul of Requirements for Supervision of Branch Offices and Guaranteed IBs:
https://www.nfa.futures.org/news/PDF/CFTC/Interp-Notice-CR%202-9-Supervision-Branch-Offices-GIBs-052119.pdf

SEC Adopts New Regulation to Ensure Retail Customers’ Best Interest Takes Priority Over Broker-Dealer’s:

SEC Kicks Canada-Based ICO Issuer; Claims It Conducted Unregistered Securities Offering to US Persons:
https://www.sec.gov/litigation/complaints/2019/comp-pr2019-87.pdf

SEC OCIE Summarizes Observed Best Practices for Storage of Customers’ Electronic Records by Broker Dealers and Investment Advisors:
https://www.sec.gov/files/OCIE%20Risk%20Alert%20-%20Network%20Storage.pdf

Where’s the CFTC v. Agricultural Food Giants’ Purported Manipulation Settlement?:
/ckfinder/userfiles/files/CFTC%20v_%20Kraft%20Continuation.pdf

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of June 8, 2019. 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. Views of the author may not necessarily reflect views of Katten Muchin or any of its partners or employees.

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