Bridging the Week by Gary DeWaal


Bridging the Week by Gary DeWaal: August 4 to 8 and 11, 2014 (Manipulation, Falsification, Position Limits Criticism, Sour Grapes of Wrath)

Bridging the Week    Compliance Weeds    Exchanges and Clearing Houses    Federal Energy Regulatory Commission    Manipulation    Position Limits    Trade Practices (including Disruptive Trading)    Valuable Lessons Learned   
Published Date: August 10, 2014

Fitting for the dog days of August in the United States, the US Commodity Futures Trading Commission demonstrated it has both a meaningful bark and bite by settling two high profile enforcement actions: one against alleged manipulators of crude oil futures and another against an alleged falsifier of internal trading records of his employer. In an unrelated development, industry participants roundly criticized CFTC proposed position limits rules in the final days of a re-opened comment period.

As a result, the following matters are covered in this week’s Bridging the Week:

  • CFTC Settles Crude Oil Manipulation Action Against Parnon Energy and Other Defendants for US $13 Million Fine;
  • Flurry of Opposing Views Greets CFTC’s Position Limits Proposal in Final Days of Comment Period;
  • Former Citigroup Director Settles CFTC Lawsuit for Mismarking and Inflating the Value of Ethanol Futures to Hide Trading Losses (includes Valuable Lessons Learned);
  • Fed and FDIC Strongly Criticize Resolution Plans of 11 Banking Organizations;
  • CME Clarifies When Netting Cannot Occur in Spot Month Positions in Physically Delivered Contracts (includes Compliance Weeds);
  • ESMA Issues Guidelines and Recommendations to Implement CPSS-IOSCO Financial Market Infrastructure Principles for Clearinghouses; But There’s Just One;
  • The Sour Grapes of Wrath: Judge Approves SEC Citigroup CDO Settlement;
  • FERC Issues Notice of Alleged Violations Against Private Fund That Posts Defenses on Internet;
  • SEC Charges So-Called “Nickel” Broker-Dealer and President With Net Capital and Recordkeeping Violations; President Also Criminally Charged for Obstructing SEC’s Investigation;
  • LME Inaugurates Commitments of Traders Publication; 
  • ICE Futures Europe Postpones Rollout of EMIR-Compliant Customer Segregation Rules; and more.

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Article Version:

CFTC Settles Crude Oil Manipulation Action Against Parnon Energy and Other Defendants for US $13 Million Fine

Five defendants agreed to settle a Commodity Futures Trading Commission enforcement action involving their alleged manipulation and attempted manipulation of crude oil futures from late 2007 through April 2008 by consenting to payment of a US $13 million civil penalty.

The defendants are Parnon Energy Inc., Arcadia Petroleum Ltd., Arcadia Energy (Suisse) SA, James Dyer, and Nicholas Wildgoose.

The CFTC had alleged that the defendants engaged in a manipulative strategy by accumulating a large quantity of physical crude oil that satisfied relevant delivery requirements of crude oil futures contracts traded on the New York Mercantile Exchange and ICE Futures Europe in order to “dominate and control” the relevant supply although they had no business need. At the same time, the defendants purchased long futures positions on the relevant NYMEX and ICE crude oil contracts to help drive up the value of their physical positions. The CFTC claimed the defendants later sold short the same futures contracts at “artificially high prices,” and subsequently sold off their physical positions unexpectedly. This drove down crude oil futures prices dramatically, thus increasing the value of defendants’ short futures positions.

In settling this matter, none of the defendants admitted or denied any of the CFTC’s substantive allegations in the complaint. In addition to agreeing to pay a civil penalty, the defendants consented to various undertakings in order to resolve this matter.

(For a related reading click here, to see the article “Federal Judge Blocks Defendants’ Subpoena for Identity of Confidential Informant in CFTC Manipulation Action,” in the May 26 – 30 and June 2, 2014 edition of Bridging the Week.)

Flurry of Opposing Views Greets CFTC’s Position Limits’ Proposal in Final Days of Comment Period

The CFTC received a flurry of letters during the last few days of a re-opened comment period in response to its Fall 2013 proposals to establish position limits on 28 agricultural, energy and metals futures contracts, as well as on options and swaps that are economically equivalent to such contracts, and to amend its aggregation policy. In all, the Commission received more than 265 letters, most of which were critical of its proposals.

In general, commentators requested that the Commission expand the definition of bona fide hedging, provide a more efficient process to request non-enumerated hedging exemptions, and relax its aggregation proposal.

For example, the National Grain and Feed Association – which says it represents 1,000 companies that operate 7,000 US facilities in the grain, feed and processing industry – argued against a too restrictive definition of bona fide hedging. According to the Association,

[we believe] strongly that strategies historically utilized by commercial hedgers to reduce and manage business risk – and long recognized by the CFTC as bona fide hedges – cannot now be thrown into question or written out of a new definition. To do so would be to expose these businesses, the farmer-customers with whom they are working to price and market their crops and US consumers to increased risk, lower price bids and fewer risk-management alternatives for farmers and ranchers, and higher costs to consumers.

Similarly, the National Council of Farmer Cooperatives – which claims to represent two million farmers and ranchers that belong to one or more farmer cooperatives – criticized the CFTC’s proposed process to handle requests for non-enumerated hedge exemptions. According to the Council,

the process for exemption appears to lead to a lengthy open-ended review by the Commission, whether or not it is commonly used as a risk management practice that previously has been recognized as a bona fide hedging exemption.

The Chicago Mercantile Exchange strongly criticized the Commission’s aggregation proposal which it claims is based on the “unprecedented notion that hedging on an ‘enterprise-wide’ basis across affiliated but independently organized and managed entities is conventional.” However, says the CME,

equating an ownership interest in a separately organized entity… with an ownership interest in the owned entity’s futures and swaps “accounts” is unauthorized by [applicable law] and has not been a “longstanding” Commission precedent that has been consistently administered by the agency across all markets.

Not all views were critical of the CFTC, however. For example, at least one commentator, Occupy the SEC, asked for the Commission to err on the side of being restrictive in its interpretations. According to this organization, “[w]e share with leading advocates and academics the view that strict position limits are necessary to ensure against manipulative and speculative practices that have caused abrupt changes in the price and supply of vital natural resources.”

And briefly:

  • Former Citigroup Director Settles CFTC Lawsuit for Mismarking and Inflating the Value of Ethanol Futures to Hide Trading Losses: John Brooks, a former director and trader for Citigroup, Inc., agreed to settle charges by the CFTC that, from November 2010 through October 2011, he cheated and defrauded his employer when he concealed trading losses by mismarking and inflating the value of certain futures contracts in his trading account. In connection with his settlement, Mr. Brooks agreed to pay a fine of US $500,000, be barred forever from registering with the CFTC in any capacity, and be banned from trading any CFTC-regulated product for seven years, among other penalties. The CFTC had filed a civil enforcement action against Mr. Brooks in September 2013, after Citigroup and an affiliate sustained trading losses in excess of US $40 million as a result of his conduct. The Commission alleged that, during the relevant time, Mr. Brooks was responsible for “valuing and reporting the value of his ethanol futures positions in his trading book.” Mr. Brooks took advantage of the manual process required for fulfilling this function, says the CFTC, by entering “falsely inflated ethanol futures values” into a Citibank affiliate’s internal trade booking and valuation computer system. Mr. Brooks did not admit or deny any of the CFTC’s allegations in agreeing to the settlement.

Valuable Lessons Learned: Nick Leeson, Joseph Jett, Toshihide Iguchi, John Rusnak, Jerome Kerviel, Kweku Adaboli, and many others. The list of infamous rogue traders in financial services is far too long and, my guess is that other names will be added to this dishonor roll regrettably too. Why? Despite all the publicity surrounding rogue trading events, firms over time let down their guard, and common sense operational risk controls fall by the wayside, whether for budgetary considerations, temporary business expedience that becomes too long term or otherwise. There are common denominators among rogue trading events – the so-called four elements of the “fraud diamond” – opportunity, motivation, rationalization and capability. Within the opportunity category, there are often common operational breakdowns: lapses or holes in firm reconciliation practices; overlap in responsibilities between front and back office personnel; and technological deficiencies. Firm culture plays a major role in rogue trading too. Companies should minimize fragmentation among control units to ensure that anomalies are capable to be identified early and staff should be repeatedly trained in fraud prevention. Moreover, a firm’s culture should encourage the reporting of potentially problematic matters.

  • Fed and FDIC Strongly Criticize Resolution Plans of 11 Banking Organizations: The Board of Governors of the Federal Reserve System and the Board of Directors of the Federal Deposit Insurance Corporation criticized the resolution and recovery plans of 11 banking organizations under their joint oversight. Each of the organizations was required under the Dodd-Frank Act to submit resolution plans to these regulators because they maintain consolidated assets of at least US $50 billion. Common features of the organizations’ deficiencies included relying on assumptions regarding “the likely behavior of customers, counterparties, investors, central clearing facilities and regulators” that the regulators considered unrealistic or insufficiently supported, and failing to propose structural changes or amendments to practices to augment prospects for orderly resolution. Each of the 11 institutions will be required by the regulators to show they are making sufficient progress to address the deficiencies in annual plans they must submit by July 1, 2015. (For a list of the 11 firms, click here to view the Fed and FDIC announcement included in the For More Information section, below.) 
     
  • CME Clarifies When Netting Cannot Occur in Spot Month Positions in Physically Delivered Contracts: The CME Group has proposed amendments to its rules to clarify that generally, no netting may occur by an owner in connection with concurrent long and short positions in physically-delivered physical contracts once spot month position limits become applicable and for all days afterwards. During such time, concurrent long and short positions may only be offset in the marketplace, except for positions resulting from bona fide clerical or operational errors. Under these limited circumstances positions may be offset by netting, transfer or position adjustment provided they do not constitute more than two percent of open interest in the affected month. These amendments are scheduled to be effective August 19.

Compliance Weeds: Future commission merchants and foreign brokers can help their clients by maintaining procedures to ensure that instruct or leave-open accounts are consulted in advance of the relevant day where offsets are no longer permitted, to ensure that desired offsets are implemented. Otherwise a client can end up taking market exposure and paying unexpected commissions when liquidating positions in the marketplace.

  • ESMA Issues Guidelines and Recommendations to Implement CPSS-IOSCO Financial Market Infrastructure Principles for Clearinghouses; But There’s Just One: The European Securities and Markets Authority adopted so-called “guidelines and recommendations” for European regulators to help ensure that European-based clearing houses (CCPs) comply with the principles of financial market infrastructure adopted in April 2012 by the Committee on Payments and Settlement Systems of the Bank for International Settlements and the International Organization of Securities Commissions. At this time, however, the sole guideline adopted by ESMA is that regulators, when authorizing and supervising CCPs within their territory, should ensure that they comply with the PFMIs “and operate in a manner that is consistent with them.” ESMA determined it was necessary to issue this formal guideline because “the regulatory framework under European Market Infrastructure Regulation does not always employ the same operative language as used in the PFMIs.” ESMA was concerned that, without this guidance, CCPs might not be recognized as having implemented the PFMIs which would have adverse capital consequences on banks having exposures to them. The PFMIs are high-level best practices for all financial exchanges and CCPs (but mostly CCPs) that set forth standards for organization, credit and liquidity risk management, settlement, default management, general business and risk management, and other topics. (To access these principles, click here.) 
     
  • The Sour Grapes of Wrath: Judge Approves SEC Citigroup CDO Settlement: Last week, Judge Jed Rakoff of the US District Court in NY approved a US $285 million settlement between the Securities and Exchange Commission and Citigroup Global Markets related to the Agency’s 2011 lawsuit against the bank over its structure and sale, beginning in 2007, of a collateralized debt obligation mostly secured by subprime securities. Citigroup’s settlement includes payment of a fine of US $95 million. Judge Rakoff previously had declined to approve the settlement but a court of appeals subsequently ruled that he had misapplied applicable legal standards in doing so. (For details, click here to see the article “Second Circuit Reverses District Court’s Refusal to Approve SEC Settlement with Citigroup” in the June 2 – 6 and 9 edition of Bridging the Week.) As his rationale for approving the settlement at this time, Judge Rakoff noted, “They who must be obeyed have spoken and this court’s duty is to faithfully fulfill their mandate… [The court of appeals] has now fixed the menu, leaving this court with nothing but sour grapes.” 
     
  • FERC Issues Notice of Alleged Violations Against Private Fund That Posts Defenses on Internet: The Federal Energy Regulatory Commission issued a notice of a non-public investigation against a private investment firm, Powhatan Energy Fund LLC, claiming it engaged in wash trades to collect over US $11.5 million in power market rebates between June 1 and August 3, 2010. The alleged wrongful conduct involved so-called “up to congestion” (UTC) transactions in the PJM Interconnection LLC regional transmission organization (PJM coordinates the movement of wholesale electricity among all or parts of 13 states in the Northeast and Midwest; UTC trading permits hedging the difference in locational prices of electricity). FERC apparently has been reviewing this matter since at least 2010, prompting Powhatan to maintain a webpage that explains its defenses, including a video summary of the fund’s position and video testimonials of various experts. Also named in the investigation were Houlian (Alan) Chen, the principal trader for Powhatan, Heep Fund Inc., and CU Fund Inc. If FERC and the respondents do not resolve this matter amicably, the Commission may commence a formal enforcement proceeding by issuing an order to show cause.
     
  • FERC Settles Enforcement Proceeding Against Imperial Irrigation District Over 2011 Pacific Southwest Blackout: The Imperial Irrigation District agreed to pay a civil penalty of US $12 million to FERC and the North American Electric Reliability Corporation related to its role in a 2011 blackout in the Pacific Southwest, impacting 2.7 million customers. FERC claims that the blackout was exacerbated by the utilities’ failure to comply with reliability standards it enacted in 2007. US $9 million of the penalty will be used to enhance the utilities’ reliability. NERC is a not for profit international organization (in the US under the oversight of FERC) responsible for ensuring the reliability of bulk electric power systems in North America.
     
  • SEC Charges So-Called “Nickel” Broker-Dealer and President with Net Capital and Recordkeeping Violations; President Also Criminally Charged for Obstructing SEC’s Investigation: The SEC charged Crucible Capital Group, a broker-dealer, and Charles Moore, its founder, president and sole shareholder, with violating the firm’s net capital requirements from December 2012 to September 2013, and with preparing and maintaining false records to facilitate the violation. During the relevant time, Crucible typically was required to maintain at least US $5,000 in net capital, the minimum amount required by a broker-dealer under SEC rules. Mr. Moore allegedly utilized an affiliate of Crucible to help inflate the reported net capital of the firm, by having third-party vendors send their charges to the affiliate. These charges were not disclosed on Crucible’s records. Separately, criminal charges were filed against Mr. Moore by the US Attorney’s Office in Manhattan for having a Crucible employee falsify certain invoices received from third-party vendors by removing mention of past due balances. These altered invoices were subsequently given to the SEC during an examination of Crucible, the US Attorney’s Office claims.

And even more briefly:

  • LME Inaugurates Commitments of Traders Publication: The London Metal Exchange began publication of weekly commitments of traders reports to disclose the principal business activity for which LME members and their clients use the exchange. The reports will be published each Tuesday summarizing for each business day of the prior week the daily open interest broken down by five categories of users including producer/merchant/processor/user; broker-dealer/index trader; and money manager. The CFTC also publishes a commitments of traders report, on a weekly basis, based on markets it oversees where 20 or more traders maintain open positions above its large trader reporting levels.
     
  • ICE Futures Europe Postpones Rollout of EMIR-Compliant Customer Segregation Rules: ICE Futures Europe has postponed the implementation date of rule amendments to address new customer segregation requirements under EMIR. These amendments were scheduled to go into effect on August 4, but are now delayed until the completion “of all regulatory processes.” (For related reading, click here to see the article “LCH.Clearnet LTD Authorized as CCP under EMIR; US FCMs Struggle with Application of EMIRs Individual Segregation Accounts’ Offer Requirement” in the June 9 – 13 and 16, 2014 edition of Bridging the Week.) 
     
  • IOSCO Publishes Central Clearing Requirements Product-by-Product, Jurisdiction-by-Jurisdiction: IOSCO has initiated periodic publication of a matrix of OTC derivatives that are subject to mandatory clearing requirements. This matrix lists relevant derivatives product by product and jurisdiction by jurisdiction, and notes eligible central clearinghouses and potential exemptions, among other information.
     
  • SEC Publishes List of Registered Alternative Trading Systems: The SEC published a list of alternative trading systems (including so-called dark pools) that were registered with it as of August 1.
     
  • IOSCO Solicits Views on the Effects of Warehouses on Commodity Derivatives Prices: IOSCO has issued a questionnaire to help it research the impact of warehouses on the price formation of physically delivered commodity derivatives. Comments are due by October 31.
     
  • UK FCA Seeks Input on Proposed Social Media Guidance: The UK Financial Conduct Authority seeks views by November 6 regarding its proposed guidance on the use of social media by financial intermediaries. The principle requirement of promotions is that they be “fair, clear and not misleading.” However, “[f]irms should consider the appropriateness of character-limited media as a means of promoting complex features of financial products or services,” says the FCA.
     
  • CoCo Securities Prohibited for Retail Investors by FCA: The FCA has prohibited the distribution of contingent convertible securities (CoCos) to retail investors, and has limited their sale to professional, institutional and sophisticated or high net worth persons. CoCos are typically debt securities that are converted into equity when the issuer’s capital position materially declines. Last week, the three European Supervisory Authorities issued an advisory regarding CoCos. (For details, click here to see the article “Joint Committee of ESAs Cautions EU Banks and Insurance Companies About Placing Their Own Financial Products With Retail Investors” in the July 21 – August 1 and 4, 2014 edition of Bridging the Week.) 
     
  • FIA and FIA PTG Provide Suggestions to CFTC Regarding Data Collection and Market Surveillance: FIA and the FIA Principal Traders Group filed a comment letter with the CFTC proposing principles the Commission should follow in amending its surveillance systems. Among other recommendations, the organizations urged the CFTC to continue “delegating front-line surveillance responsibilities to exchanges,” and “[a]void building new systems, data stores, and surveillance routines that replicate those built or commissioned by existing exchanges.”

For more information, see:

CFTC Settles Crude Oil Manipulation Action Against Parnon Energy and Other Defendants for US $13 Million Fine:
http://www.cftc.gov/ucm/groups/public/@lrenforcementactions/documents/legalpleading/enfparnonorder080414.pdf

See also Initial Complaint: CFTC v. Parnon Energy Inc., et al:
http://www.cftc.gov/ucm/groups/public/@lrenforcementactions/documents/legalpleading/enfparnoncomplaint052411.pdf

CME Clarifies When Netting Cannot Occur in Spot Month Positions in Physically Delivered Contracts:
http://www.cmegroup.com/tools-information/lookups/advisories/market-regulation/files/SER-7150.pdf

CoCo Securities Prohibited for Retail Investors by FCA:
http://www.fca.org.uk/static/documents/temporary-product-interventions/restrictions-in-relation-to-the-retail-distribution-of-cocos.pdf

ESMA Issues Guidelines and Recommendations to Implement CPSS-IOSCO Financial Market Infrastructure Principles for Clearinghouses; But There’s Just One:
http://www.esma.europa.eu/system/files/2014-1009.pdf

Fed and FDIC Strongly Criticize Resolution Plans of 11 Banking Organizations:
http://www.federalreserve.gov/newsevents/press/bcreg/20140805a.htm

FERC Issues Notice of Alleged Violations Against Private Fund That Posts Defenses on Internet:
http://www.ferc.gov/enforcement/alleged-violation/notices/2014/houlian-08-05-2014.pdf

See also Powhatan Website Setting Forth Its Defenses:
http://ferclitigation.com

FERC Settles Enforcement Proceeding Against the Imperial Irrigation District Over 2011 Pacific Southwest Blackout:
http://www.ferc.gov/CalendarFiles/20140807085730-IN14-7-000.pdf

FIA and FIA PTG Provide Suggestions to CFTC Regarding Data Collection and Market Surveillance:
http://www.futuresindustry.org/downloads/CFTC%20Surveillance%20080414.pdf

Flurry of Opposing Views Greets CFTC’s Position Limits Proposal on Final Days of Comment Period:
http://comments.cftc.gov/PublicComments/CommentList.aspx?id=1505&ctl00_ctl00_cphContentMain_MainContent_gvCommentListChangePage=1

Former Citigroup Director Settles CFTC Lawsuit for Mismarking and Inflating the Value of Ethanol Futures to Hide Trading Losses:
http://www.cftc.gov/ucm/groups/public/@lrenforcementactions/documents/legalpleading/enfbrooksorderdf080114.pdf

See also Initial Complaint: CFTC v. John Brooks:
http://www.cftc.gov/ucm/groups/public/@lrenforcementactions/documents/legalpleading/enfbrookscomplaint092713.pdf

ICE Futures Europe Postpones Rollout of EMIR-Compliant Customer Segregation Rules:
https://www.theice.com/publicdocs/circulars/14088.pdf

See also, Proposed Amendments to ICE Futures Rules to Accommodate EMIR Customer Segregation Requirements:
https://www.theice.com/publicdocs/circulars/14084.pdf
https://www.theice.com/publicdocs/circulars/14084_Attach_1.pdf

IOSCO Publishes Central Clearing Requirements Product by Product, Jurisdiction by Jurisdiction:
http://www.iosco.org/library/index.cfm?section=information_repositories

IOSCO Solicits Views on the Effects of Warehouses on Commodity Derivatives Prices:
https://www.iosco.org/surveys/2014-Storage-Infrastructure/?page=signup

LME Inaugurates Commitments of Traders Publication:
https://www.lme.com/metals/reports/commitments-of-traders/

SEC Charges So-Called “Nickel” Broker Dealer and President With Net Capital and Recordkeeping Violations; President Also Charged Criminally For Obstructing SEC’s Investigation:
http://www.sec.gov/litigation/admin/2014/34-72797.pdf

See also Criminal Complaint Against Charles Moore:
http://www.justice.gov/usao/nys/pressreleases/August14/CharlesMooreArrest/Moore,%20Charles%20Complaint.pdf

SEC Publishes Lists of Registered Alternative Trading Systems:
http://www.sec.gov/foia/ats/atslist0814.pdf

The Sour Grapes of Wrath: Judge Approves SEC Citigroup CDO Settlement:
http://knowledgemosaic.com/gateway/courtcase/Citigroup.080514.pdf

See also Initial SEC Complaint v. Citigroup Global Markets:
http://www.sec.gov/litigation/complaints/2011/comp-pr2011-214.pdf

UK FCA Seeks Input on Proposed Social Media Guidance:
http://www.fca.org.uk/static/documents/guidance-consultations/gc14-06.pdf

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of August 9, 2014. 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 and/or Gary DeWaal 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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