A broker-dealer and its chief executive officer settled charges brought in 2017 by the Securities and Exchange Commission that the firm facilitated manipulative conduct by a customer, despite being alerted by regulators and an insider at the client that the customer might be engaging in spoofing trading. Unrelatedly, while the new chair of the Commodity Futures Trading Commission proclaimed the digital currency ether a commodity and said there soon might be futures or other derivatives contracts based on the second-largest market cap cryptocurrency, the SEC once again stymied the listing of an exchange-traded fund based on bitcoin. As a result, the following matters are covered in this week’s edition of Bridging the Week:
According to the SEC, Avalon engaged in spoofing trading involving stocks “in hundreds of thousands of instances” between approximately December 2010 through at least September 2016 by placing orders it did not intend to execute on one side of a market in order to induce executions on the other side. The SEC also claimed that Avalon engaged in cross-market manipulation by buying and selling stock at a loss in order to impact the price of corresponding options in order to trade the derivatives at artificial prices to make profits. This activity, said the SEC, occurred from at least August 2012 through at least December 2015.
The SEC claimed that Lek Securities and Mr. Lek helped Avalon engage in its purportedly illicit conduct by providing the non-US firm access to US markets, relaxing Lek Securities’ layering controls after Avalon objected, and improving Lek Securities’ technology to help Avalon’s trading. In the complaint, the SEC charged that Lek Securities and Mr. Lek had a significant motive to assist Avalon because, from 2012 through 2016, the firm “was Lek’s highest producing customer in terms of commissions and fees and rebates generated.”
The SEC also alleged that Lek Securities and Mr. Lek were aware of Avalon’s improper activities when, among other things, Mr. Lek received an email in May 2012 explicitly describing the layering scheme from an individual who shortly afterwards became an Avalon trade group leader, as well as when regulators, exchanges and other market participants told Lek Securities and Mr. Lek on various occasions that they were concerned Avalon was engaging in layering. In many instances, said the SEC, the regulators provided Lek Securities and Mr. Lek with “detailed descriptions” of Avalon’s supposed problematic conduct.
To resolve the SEC’s complaint, Lek Securities agreed to pay a fine of US $1 million and US $525,892 in disgorgement and prejudgment interest and Mr. Lek consented to remitting a US $420,000 fine. Lek Securities also agreed to certain other sanctions including not providing intraday-trading access to foreign customers except under limited prescribed circumstances, and retaining a compliance monitor for three years. Both Lek Securities and Mr. Lek admitted that Avalon’s trading activities as alleged in the complaint constituted violations of federal securities laws as part of their settlement.
Compliance Weeds: In early 2018, the Commodity Futures Trading Commission and the Department of Justice coordinated announcements regarding the filing of civil enforcement actions by the CFTC, naming five corporations and six individuals, and criminal actions by the DOJ against eight individuals – including six of the same persons named in the CFTC actions – for engaging in spoofing activities in connection with the trading of futures contracts on US markets. Two of the corporations that resolved their CFTC enforcement actions were Deutsche Bank AG and its wholly owned subsidiary Deutsche Bank Securities Inc., a CFTC-registered futures commission merchant; they agreed to jointly and severally pay a fine of US $30 million. Although the purported problematic trading activity was undertaken by employees of DB, DBSI was named in this action because of its alleged failure to supervise.
According to the CFTC, while DBSI maintained a surveillance system that detected many instances of potential spoofing by DB traders, it failed to follow up on “the majority” of potential flagged issues. (Click here for background on the multiple CFTC and DOJ actions in the article “CFTC Names Four Banking Organization Companies, a Trading Software Design Company and Six Individuals in Spoofing-Related Cases; the Same Six Individuals Criminally Charged Plus Two More” in the February 4, 2018, edition of Bridging the Week.)
In 2016, the CFTC named Advantage Futures LLC, another FCM, in an enforcement action related to the firm’s handling of the trading account of one customer in response to three exchanges’ warnings, among other matters. The firm and the two officers that were named as defendants agreed to pay a fine of US $1.5 million to resolve the CFTC action.
According to the CFTC, between June 2012 and April 2013, three exchanges alerted Advantage to concerns they had regarding the trading of one unspecified customer’s account which they considered might constitute disorderly trading, spoofing and manipulative behavior, in violation of the exchanges’ relevant rules. The CFTC claimed that Advantage initially failed “to adequately respond to the [exchanges’] inquiries and did not conduct a meaningful inquiry into the suspicious trading.” Only after the three exchanges threatened to hold Advantage responsible for its customer’s conduct did Advantage cut off the trader’s access to the three exchanges. However, Advantage purportedly failed to augment its oversight of the trader’s remaining trading or control his access to other exchanges “despite knowing that he employed the same strategy across all markets.” (Click here for background in the CFTC enforcement action against Advantage Futures in the article “FCM, CEO and CRO Sued by CFTC for Failure to Supervise and Risk-Related Offenses,” in the September 25, 2016 edition of Bridging the Week.)
Both the DBSI and Advantage cases suggest that, like the SEC, the CFTC believes that FCMs have some type of oversight responsibility related to their customers’ trading to help ensure market integrity and must take some appropriate action when they have knowledge of potential wrongdoing.
Separately, the Securities and Exchange Commission disapproved rule changes proposed by NYSE Arca, Inc. to list and trade shares of the Bitwise Bitcoin ETF Trust. The Commission claimed that NYSE Arca’s proposed rules were not adequately designed “to prevent fraudulent and manipulative acts and practices.” The SEC said the NYSE Arca failed to demonstrate that the spot market in bitcoin is “inherently resistant to fraud and manipulation” or alternatively that it had entered into a surveillance-sharing agreement with a regulated market of “significant size” relating to bitcoin. Although NYSE Arca entered into a surveillance-sharing agreement with the Chicago Mercantile Exchange that lists a bitcoin futures contract, the SEC claimed it was not of “sufficient size.”
Bitwise Asset Management, Inc., the sponsor of the proposed exchange-traded product, had claimed that there was effectively a bifurcated market for bitcoin, comprised 95 percent of “fake and non-economic activity” and the remainder by the legitimate activity of 10 firms that were either regulated by the Financial Enforcement Crimes Network and/or the New York Department of Financial Services, or had significant compliance practices. The sponsor said its ETF would be based on prices from the 10 firms – Binance, Bitfinex, Coinbase Pro, Kraken, Bitstamp, bitFlyer, Gemini, itBit, Bittrex and Poloniex. The SEC rejected Bitwise’s analysis, claiming the 10 exchanges were not regulated markets comparable to a national securities exchange or futures exchange “although [some] may be registered with FinCEN or NYSDFS.” The SEC also said that the CME’s bitcoin futures volume was not sufficiently substantial compared to the overall bitcoin-traded volume to make the CFTC-regulated exchange of “sufficient size.”
In declining NYSE Arca’s rule change, the SEC said that “its disapproval does not rest on an evaluation of whether bitcoin or blockchain technology more generally, has utility or value as an innovation or an investment.”
In other legal and regulatory developments regarding cryptoassets:
According to the statement, relevant CFTC registrants’ BSA Obligations will be overseen by the CFTC, FinCEN and the National Futures Association for all activities within the entities’ perimeters, including those that may not be subject to regulation under the Commodity Exchange Act. Relevant CFTC registrants are futures commission merchants, introducing brokers, commodity trading advisors, commodity pool operators, swap dealers, major swap participants and retail foreign exchange dealers.
Likewise, relevant SEC registrants’ BSA Obligations will be overseen by the SEC, FinCEN and a self-regulatory organization (likely the Financial Industry Regulatory Authority) for all activities conducted under the entities’ umbrellas including those that may not be subject to regulation under US securities laws. Relevant SEC registrants are broker-dealers and open-end investment companies known as mutual funds.
The joint statement implied that persons required to register with the SEC and/or CFTC for any reason would not also be required to register with FinCEN as a money service business, however.
My View: In July 2018, the SEC disapproved a proposed rule change by the Bats BZX Exchange, Inc. to permit its listing and trading of shares of the Winklevoss Bitcoin Trust. Commissioner Hester Peirce dissented from the Commission’s determination. She claimed that BZX’s proposed rule change “satisfies the statutory standard” and that the SEC’s refusal to approve the rule “sends a strong signal that innovation in unwelcome in our markets, a signal that may have effects far beyond the fate of bitcoin [exchange-traded product].”
Commissioner Peirce’s dissent was spot on then, and applies equally to the Commission’s rejection last week of NYSE Arca’s proposal to list and trade shares of the Bitwise Bitcoin ETF Trust. There is no language in the relevant statute that appears to require NYSE Arca to address trading in spot bitcoin, as opposed to the exchange-traded product it proposed to accommodate, in a defense of its rules intended to preclude fraudulent and manipulative conduct. The language of the relevant statute is clear:
An exchange shall not be registered as a national securities exchange unless the Commission determines that
(5) The rules of the exchange are designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to foster cooperation and coordination with persons engaged in regulating, clearing settling, processing information with respect to, and facilitating transactions in securities, to remove impediments to and perfect the mechanisms of a free and open market and a national market system, and, in general, to protect investors and the public interest.
(Emphasis added; click here to access 15 U.S.C. § 78f(b)(5).)
Nothing in this provision suggests that an exchange must address the potential for fraud or manipulation on another exchange or trading facility, let alone in the over-the-counter market, in order for its rules related to the listing of a specific security to be approved by the SEC.
According to Ms. Peirce, BZX more than adequately met its requirement under the plain language of the law, and there was no suggestion in the NYSE Arca order that the exchange had failed to meet its burden either. (Click here to access the Dissent of Commissioner Peirce to Release No. 34-83723; File No. SR-BatsBZX-2016-30, July 26, 2019.)
Moreover, the SEC’s rejection of NY DFS’s oversight of exchanges through its BitLicense program seems disrespectful if not demeaning. Comparable does not mean equal, and although NY DFS may not impose all the same obligations on regulated virtual currency exchanges as the SEC does on national securities exchanges, that is not a sufficient basis for concluding the oversight is not comparable.
No matter what the words of the SEC are to the contrary, its continued refusal to approve the listing of a bitcoin ETP appears to be a vote against new technology.
The defendants sought a finding of contempt and other sanctions against the CFTC alleging the Commission violated a mutual gag order contained in the settlement order when, among other things, two commissioners issued concurring opinions when the CFTC publicized the settlement, and the CFTC issued its own press release and statement.
In seeking a mandamus order, the CFTC sought to preclude Judge Blakey – the district court judge that presided over the settlement process – from conducting an evidentiary hearing in connection with the contempt proceeding, claiming that it would be of the nature of a criminal inquisition. Alternatively, the CFTC requested that Judge Blakey be removed from presiding over any evidentiary hearing. (Click here for details in the article “District Court Inquisition is Unlawful Argues CFTC in Opposing Potential Contempt Finding and Other Sanctions Arising From Enforcement Action Settlement with Two Food Giants? in the October 6, 2019 edition of Bridging the Week.)
In a letter to the court of appeals, Judge Blakey said that the CFTC’s petition “is not ripe.” Although he implicitly conceded that the CFTC might have initially and fairly determined that the evidentiary hearing was intended to be a criminal proceeding, he clarified that it was intended to be a “civil proceeding” subsequent to reviewing the Commission’s appellate motion. As a result, he wrote, “I believe it’s important to note that the CFTC’s fears of an unlawful criminal inquisition are unfounded.”
Likewise, defendants filed papers with the court of appeals also indicating that the CFTC’s petition was untimely because the district court has made no ruling. Defendants argued that if Judge Blakey “in the future enters a sanction in error or based on inadmissible evidence, any error can be corrected by a direct appeal once he enters a contempt judgment.” Kraft and Mondelez also argued that no criminal inquest is “pending or threatened” and that Judge Blakey has the “inherent authority” to hold hearings to assess compliance with his own order.
My View: A litigation with three parties – a plaintiff, two defendants and the presiding judge. Wow! As I wrote before, this post-settlement proceeding is an episode out of The Twilight Zone. It only gets stranger.
According to FCA, TPEL's name passing' broking business constituted a significant percentage of TPEL's overall business and generated a large part of the firm's overall revenue. The business depended on "strong relationships" between TPEL's brokers and employees of their institutional clients including a large amount of entertainment. TPEL's brokers' compensation was a function of commissions they generated from their clients.
FCA charged that seven TPEL traders orchestrated 17 wash sales for customers between 2008 and 2010 solely to generate commissions. However, claimed FCA, senior management of the company “failed to act with due skill, care and diligence when they were faced with blatant signals of broker misconduct.” For example, when a senior manager inquired into a very high commission generated on a trade, the broker told him, “You don’t want to know.” In response, the senior manager made no efforts to follow up on the broker’s possible misconduct.
Additionally, FCA alleged that the firm’s compliance department conducted “no form of monitoring” regarding the firm’s name passing' broking business as the department regarded the business as low risk. Although TPEL maintained a system to capture information regarding trades, orders and commissions, the compliance department presumed it was being used by trading desk heads and division directors to detect unusual transactions but did not follow up; in fact, said FCA, there was no effective monitoring. FCA also alleged that, in August 2011, when it requested certain audio tapes from TPEL it was told they did not exist. However, some TPEL personnel were aware a majority of such tapes did exist; FCA was not advised of the tapes’ existence and TPEL’s earlier knowledge of their existence until much later and relevant tapes were not produced until 2014.
Last month, Tullett Prebon Americas Inc. ("Tullett"), a Commodity Futures Trading Commission-registered introducing broker, settled two enforcement actions by the CFTC by agreeing to pay a combined fine of US $13 million and implementing various remedial measures. In one action, the CFTC claimed that, from at least October 2, 2012, through at least December 2014, Tullett failed to adequately supervise brokers on its US Dollar Medium-Term Interest Rates Swaps Desk who allegedly made numerous false and misleading statements to customers related to certain executed trades as well as bids and offers. In the other action, the CFTC claimed that during its investigation into Tullett’s conduct, one unnamed broker made false or misleading statements or omitted material information to it during a voluntary appearance before Commission staff. (Click here for details in the article “Interdealer Broker Fined US $13 Million by CFTC for Making False or Misleading Statements to Customers and to CFTC” in the September 15, 2019 edition of Bridging the Week.)
Both TPEL and Tullett are now part of the TP ICAP Group.
Unrelatedly, in a presentation before the Association for Financial Markets in Europe’s Annual Compliance and Legal Conference, Tom Sexton, President of the National Futures Association, praised the benefits of self-regulation. He indicated that self-regulation has a “long history of working effectively,” and, in the United States, has succeeded because of the SROs’ ability to expend significant resources; gain industry insight by involving market professionals; respond quicker than government agencies in rule-making or rule enforcement in response to developments in the market; and dealing with global issues more effectively because of their authority to establish relationships with other SROs through contract, and not by national legislative acts. For SROs to be effective, posited Mr. Sexton, they require mandatory membership, industry leadership, a board and committee structure that ensures that no one industry sector dominates, the commitment of management to self-regulation, rulemaking and enforcement authority and government oversight.
Corrected subsequent to publication to conform effective date of January 1, 2020 both in text and headline.
According to the executive order specifically pertaining to guidances, “[a]gencies may impose legally binding requirements on the public only through regulations and on parties on a case by case basis through adjudication, and only after appropriate process.” As a result, the executive order requires agencies to treat guidance as nonbinding “both in law and in practice.” Agencies, under the executive order, generally include any executive department, military department, US government corporation, US government controlled corporation, or other establishment in the executive branch of the US government with certain enumerated exceptions; relevant agencies do not include independent regulatory agencies such as the Commodity Futures Trading Commission or the Securities and Exchange Commission. (Click here for authority in Executive Order 12866 (September 30, 1993), Section 3(b).) Under the new executive order, relevant agencies must establish procedures to issue guidance documents compliant with the new requirements within 300 days after the Office of Management and Budget issues an implementing memorandum regarding the new mandate.
The White House also issued a parallel executive order stating that “[n]o person should be subjected to a civil administrative enforcement action or adjudication absent prior public notice of both the enforcing agency’s jurisdiction over particular conduct and the legal standards applicable to that conduct.” The executive order mandates that a civil administrative enforcement action or adjudication may not proceed unless a respondent has “reasonable certainty or fair warning of what a legal standard administered by the agency requires.” This notice must occur through statutes or regulation and not guidance documents. Prior to every potential adjudication, relevant agencies must afford potential respondents with an opportunity to contest an agency’s proposed factual and legal determinations, and the agency must respond in writing, stating the basis for its action.
In February 2013, the CFTC sued William Byrnes and Christopher Curtin, two former NYMEX employees, for improperly disclosing nonpublic trade and customer data they learned through their jobs to a third party, Ron Eibschutz, in return for meals, drinks and entertainment.NYMEX made a motion for summary judgment, claiming it could not be held vicariously liable for the actions of its two employees under applicable law. (Click here to access Commodity Exchange Act § 2(a)(1)(B), 7 U.S.C. § 2(a)(1)(B).) The court rejected NYMEX’s legal position and said whether employees acted within the scope of their employment was a factual issue that was proper for a judge or jury to decide. The court also rejected the CFTC’s view, however, that the imposition of vicarious liability was automatic in an employer-employee situation. This is the second legal challenge by NYMEX to the CFTC's legal theory regarding its potential liability; the first was also rejected. (Click here for background on the lawsuit in the article “Court Rejects NYMEX Claim It Can't Be Liable for Improper Disclosure of Nonpublic Information by Ex-Employer" in the October 5, 2014 edition of Bridging the Week.)
For further information:
Broker-Dealer and CEO Agree to Almost US $2 Million Penalty With SEC for Facilitating Alleged Manipulative Trading by Non-US-Based Trading Firm:
FCA Sanctions Interdealer Broker GB £15.$ Million for Wash Sales and Noncooperation:
Federal Court Rules Futures Exchange Potentially Liable for Employees’ Misappropriation of Trading Information Under Respondeat Superior Theory:
Food Giants and District Court Judge Oppose CFTC Request for Mandamus Order in Ongoing Dispute Over Enforcement Settlement Gag Order:
IRS Reiterates Virtual Currency Is Property Under Tax Laws and Reporting Obligations:
New CFTC Chairman Says Ether Derivatives Likely Soon While SEC Says No to Another Bitcoin ETF:
New CFTC DSIO Head Warns Registrants Not to Consider Noncompliance Because Rules May Change and NFA Chief Lauds Self-Regulation Model:
President Throws in Doubt Value of Agency Guidances and Tightens Process for Administrative Enforcement Actions:
Private Lawsuit Claims Bitfinex and Tether-Related Companies and Persons Caused Artificial Prices in Bitcoin and Other Virtual Currencies:
Revised NFA Guidance Regarding Branch Offices’ and G-IBs’ Supervision Mandatorily Effective January 1, 2020:
SEC Obtains TRO Against ICO to Support Social Media and Blockchain Platforms After Telegraphing Warnings:
Three Federal Agencies Remind Persons Engaged in Digital Asset Activity to Comply With AML Requirements:
The information in this article is for informational purposes only and is derived from sources believed to be reliable as of October 12, 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 or any of its partners or employees.