Last week, the Financial Industry Regulatory Authority announced its regulation and examination priorities for 2016. The big surprise was that FINRA will soon be issuing to member firms monthly report cards showing possible layering or spoofing activities. In addition, a federal appeals court held that the bank funding a loan to a now defunct investment management firm just prior to its filing for bankruptcy in 2007 was on inquiry notice that something was wrong with the collateral it received to support the loan—that it included customer collateral, not just house collateral. Also, Steven A. Cohen settled failure to supervise charges by the Securities and Exchange Commission with payment of no fine. In addition, I include a special stand-alone Compliance Weeds dealing with block trades. As a result, the following matters are covered in this week’s edition of Bridging the Week:
- FINRA Will Grade Members on Culture, Supervision and Liquidity Management; BDs Not Managing Spoofing Likely to Get Bad Scores (includes My View);
- Sentinel Management’s Bank Held by Appellate Court to Have Been on Inquiry Notice of Cash-Management Firm’s Misuse of Customer Funds; Demoted to General Creditor Status;
- Steven A. Cohen Barred by SEC From Serving as Hedge Fund Supervisor for Two Years for Alleged Supervisory Failures; No Fine Assessed;
- Paying Salespersons Salary and Discretionary Bonus Is Misleading When Clients Are Told Payment Is Based on Performance Says SEC in Enforcement Action;
- CME Group Proposes to Toughen Requirements Prohibiting Exchange Access by Persons Subject to Economic Sanctions (includes Compliance Weeds); and more.
Note: In respect of the Martin Luther King holiday in the United States on January 18, the next edition of Bridging the Week will be on January 19, 2016.
FINRA Will Grade Members on Culture, Supervision and Liquidity Management; BDs Not Managing Spoofing Likely to Get Bad Scores:
The Financial Industry Regulatory Authority kicked off the new year by issuing its annual Regulatory and Examination Priorities Letter. This year, FINRA indicated that its emphasis will be on three areas: (1) culture, conflicts of interest and ethics; (2) supervision, risk management and controls; and (3) liquidity.
To evaluate a firm’s culture, FINRA indicated it will endeavor to determine if control functions “are valued” at the organization; whether breaches of policies and controls are tolerated; whether the organization proactively endeavors to identify potential risk and compliance issues; whether supervisors embody the firm’s culture; and whether subcultures that might develop within the organization contrary to the firm’s culture—for example, in branches or on trading desks—“are identified and addressed.”
FINRA likewise indicated it would key in on four areas to assess the effectiveness of members’ supervision, risk management and controls: handling of conflicts of interest, technology (including maintaining effective cybersecurity and data quality), outsourcing and anti-money laundering. According to FINRA, “[w]hile many firms have improved their cybersecurity defenses, others have not—or their enhancements have been inadequate.”
FINRA also noted it has observed “significant operational breakdowns” related to the rollout of new compliance systems. FINRA claimed,
[t]hese breakdowns can arise from coding issues, flaws that prevent the entry of information to facilitate proper implementation of controls and inadequate procedures leading to the suppression and override of automated alerts. This can lead to inadequate retention and supervision of email and other electronic communications, inaccurate position reports and problems with the identification of activity in customer accounts for review, among other things.
Additionally, FINRA said it would review whether firms’ funding plans are adequate in light of their business models. According to FINRA, this is because “[f]ailures to manage liquidity have contributed to both individual firm failures and systematic crisis.” In particular, FINRA noted it would focus on the liquidity planning and controls of high-frequency trading firms.
Finally, FINRA disclosed it anticipates issuing monthly report cards to firms that focus on layering and spoofing. According to FINRA, “[t]he report cards will provide information both with respect to instances where all of the potentially manipulative activity is occurring through the firm and where at least one portion of the activity is occurring through the firm while the remainder is effected outside the firm.” FINRA said it would monitor how firms use this information.
This is the 11th year FINRA has articulated its examination priorities at the beginning of the new year. (Click here to compare this year’s priorities with FINRA’s 2015 priories by reviewing the article, “FINRA Highlights Member Examinations Focus for 2015” in the January 11, 2015 edition of Bridging the Week.)
My View: It is very important that any reports members receive from the Financial Industry Regulatory Authority regarding potential layering or spoofing activity occurring at their organizations be of very high quality. Practically, members will feel obligated to evaluate all if not most all of any situations identified by FINRA as potentially problematic. However, the problem with any compliance report is usefully defining the parameters of the purported bad conduct that is sought to be detected. This involves an iterative process that typically takes time and a fair amount of resources. The securities industry can only hope that FINRA does not overload them with reports of potentially problematic transactions that contain mostly false positives and distracts them from using existing resources to more effectively review ongoing conduct.
- Sentinel Management’s Bank Held by Appellate Court to Have Been on Inquiry Notice of Cash-Management Firm’s Misuse of Customer Funds; Demoted to General Creditor Status: A federal appeals court in Illinois held that Bank of New York Mellon Corporation and Bank of New York (collectively, “BNYM”) were on “inquiry notice” that Sentinel Management Group, Inc. improperly used customer funds as collateral for a loan prior to the firm’s collapse in August 2007. (Sentinel was an investment management firm registered with the Commodity Futures Trading Commission as a futures commission merchant that claimed it specialized in short-term cash management for hedge funds, individuals, financial institutions and other FCMs. The firm filed for bankruptcy after it unlawfully commingled US $460 million of client securities into its house account, and used client collateral to obtain a US $321 million line of credit from BNYM.) The court noted that, at the time of the loan, at least one senior officer of BNYM questioned how Sentinel, which he mistakenly believed had only US $20 million of capital (in fact it had capital of less than US $3 million), could have sufficient collateral to secure a US $300 million loan. According to the manager, “I have to assume most of this collateral is for somebody’s else’s benefit.” The court said this and other facts in evidence before the lower court demonstrated that BNYM should not have reasonably accepted the collateral without further inquiry. As a result, the appeals court reversed the decision of the lower court, which held in December 2014 that BNYM’s acceptance of the collateral was in good faith and awarded the bank a priority status in Sentinel’s bankruptcy proceeding. The appeals court dropped BNYM’s status to that of a general creditor. Sentinel’s bankruptcy trustee also had argued that BNYM’s conduct should cause its claims to be subordinated to the claims of all creditors as an additional penalty However, the appeals court rejected this position. (Click here for a discussion of the trial court’s decision in this matter in the article, “US Judge Says Sentinel 2007 Transfers to BNY Mellon Cannot Be Reversed as Made in Good Faith” in the December 14, 2014 edition of Bridging the Week.)
- Steven A. Cohen Barred by SEC From Serving as Hedge Fund Supervisor for Two Years for Alleged Supervisory Failures; No Fine Assessed: Steven A. Cohen, founder and owner of hedge fund advisers that used his own initials, S.A.C., settled an administrative complaint brought in 2013 by the Securities and Exchange Commission, that he failed to supervise former portfolio managers Mathew Martoma, who in 2014 was convicted of insider trading and sentenced to nine years imprisonment, and Michael Steinberg. Mr. Cohen resolved the SEC’s charges by agreeing not to be associated with any broker, dealer or investment adviser in a supervisory capacity until December 31, 2017. He also agreed to various undertakings, including permitting the SEC to examine his family office firms, and retaining an independent consultant for his family office firms to assess their compliance with securities laws. The SEC imposed no fine as part of the settlement. In 2013, however, SAC companies resolved federal criminal charges of insider trading by pleading guilty and paying a fine of US $1.8 billion (click here for details of this action and resolution); Mr. Cohen has not personally been subject to criminal charges. According to the SEC, during the first half of 2008, Mr. Martoma established a large position in two biotechnology-related stocks. Accounts for which Mr. Cohen had exclusive or shared trading authority also held positions in the same two stocks, claimed the SEC. Subsequently, charged the SEC, Mr. Martoma allegedly received material nonpublic insider information that indicated that the results of clinical tests of a widely anticipated drug jointly developed by these two companies were not as successful as had been predicted. After purportedly having a short conversation with Mr. Martoma, Mr. Cohen “oversaw the liquidation of his and Martoma’s positions” in the two stocks and established short positions instead, said the SEC. The SEC claimed the trades earned Mr. Cohen’s firms approximately US $275 million “in illicit profits and avoided losses.” The SEC said “Mr. Cohen ignored red flags indicating that Martoma might have access to material nonpublic information about the clinical trial.” In agreeing to the settlement, Mr. Cohen did not admit or deny any of the SEC’s findings. Mr. Martoma has appealed his conviction, which is currently pending.
- Paying Salespersons Salary and Discretionary Bonus Is Misleading When Clients Are Told Payment Is Based on Performance Says SEC in Enforcement Action: The Securities and Exchange Commission fined JP Morgan Securities LLC US $4 million for allegedly misstating to its customers that, between March 2009 and February 2011, its registered representatives were not paid commissions, but were paid based on clients’ performance. In fact, said the SEC, the firm’s advisors were paid salary and a discretionary bonus that was not based on clients’ performance. It was based on a number of other factors. Moreover, said the SEC, on at least four occasions during the relevant time, JP Morgan employees identified the potential problem with the firm’s disclosure, but the disclosure was not corrected. JP Morgan settled this matter voluntarily, without admitting or denying any of the SEC’s findings.
- CME Group Proposes to Toughen Requirements Prohibiting Exchange Access by Persons Subject to Economic Sanctions: The CME Group is adding one new rule and amending two others to minimize the likelihood that its exchanges might be used for illicit money laundering. The changes will impose new obligations on clearing members. CME Group currently requires clearing members to have a written program to ensure they do not conduct business with persons named or from countries subject to economic sanctions (collectively “Sanctioned Parties”) by the US government. (Click here to access CME Group rule 981.) Under CME Group’s new provisions, clearing members (1) who become aware they are carrying an account or positions for a Sanctioned Party must "immediately" take steps to cancel all direct or indirect access of the Sanctioned Party to CME Group markets and notify CME Group of such cancellation (or work with CME Group to coordinate the cancellation of such access); (2) are prohibited from accepting debt or equity issued by a Sanctioned Party as performance bonds; and (3) may only carry omnibus accounts for other futures brokers who have received a notice saying they are prohibited from dealing themselves with Sanctioned Parties, and who provide such notice themselves to their own omnibus accounts. CME Group’s new provisions will be effective February 29, 2016, absent objection by the Commodity Futures Trading Commission.
Compliance Weeds: The beginning of the year—before it gets too busy—provides an excellent opportunity for firms to review all control-group manuals, including compliance and anti-money laundering policies and procedures. Commodity Futures Trading Commission and Securities and Exchange Commission overseen brokerage-type entities are subject to express AML requirements. Included below is a listing of resources published by the CFTC, SEC, the National Futures Association and the Financial Industry Regulatory Authority to assist such firms double check their AML requirements, as well as a link to resources for mutual funds and a recent Financial Crimes Enforcement Network rule proposal to require registered investment advisers to maintain a formal AML program. However, in addition to checking to ensure that applicable policies and procedures comply with relevant requirements, it is critical to ensure that (1) requirements of such policies and procedures are being followed as written, and (2) the responsibility for tasks is assigned to appropriate supervisors. For example, compliance officers might be required by a procedure to assist in helping business line supervisors comply with applicable laws, but they should not be responsible to ensure a firm complies with applicable laws. Moreover, the new year presents an excellent opportunity to test whether control-group software is accurately capturing data from all relevant sources and is utilizing or analyzing such data as expected.
SEC (for broker-dealers):
SEC: (for mutual funds):
FINCEN (re: investment advisers):
(Click here to also access the article, "FinCEN Proposes AML and SAR Requirements for Investment Advisers" in the August 30, 2015 edition of Bridging the Week.)
And more briefly:
- FX NDF SEF Approved as SEF by CFTC: The Commodity Futures Trading Commission granted temporary registration to FTSEF LLC as a swap execution facility for foreign exchange non-deliverable forward contracts. FTSEF is a subsidiary of FlexTrade Systems, Inc.
- NFA Updates Regulatory Guides to Address New FDM Rules: The National Futures Association updated two publications, Forex Transactions – A Regulatory Guide and Self-Examination for FCMs, FDMs, IBs, CPOs and CTAs, in light of recent amendments to its financial and risk management requirements for Forex Dealer Members. (Click here for details regarding these new requirements in the article “NFA Proposes Enhanced Capital and Risk Management Requirements for Retail Forex Dealer Members” in the May 31, 2015 edition of Bridging the Week.)
- Process for SD and MSP Responses to NFA Requests for Additional Information Revised: The National Futures Association has updated its registration procedures for swap dealers and major swap participants to no longer require submission of additional documentation or revisions in response to feedback letters. Instead, an SD or MSP will solely be required to file an attestation through the NFA’s Registration Documentation Submission System that it has revised its policies and procedures within whatever the time frame the NFA specified to address the Association’s comments.
- LME Provides 2016 Enforcement Guidelines: The London Metal Exchange published a menu of minimum fines for a variety of possible violations of LME rules. For example, for a minor incident of not dealing with the LME in “an open and cooperative manner” as required by its rules, the exchange says the minimum fine should be GBP 30,000; while, for a serious breach, it should be GBP 100,000. An offense of exerting “undue influence on market prices” should expect a fine of GBP 100,000 and upwards. LME said, given the “seriousness” of a market abuse violation, it “does not consider it appropriate to prescribe an indicative fine” for that offense.
- CFTC Proposes a Rule to Permit Foreign Natural Persons to Avoid Fingerprinting: The Commodity Futures Trading Commission proposed a rule amendment that sets forth an alternative to fingerprinting for certain foreign natural persons applying for registration with it. Instead, the person’s sponsoring firm could complete a criminal history background check. Fingerprints are currently ordinarily required for all natural person registration applicants to help evaluate their fitness. Certain foreign natural persons are currently excluded from this requirement, subject to conditions, by CFTC staff-issued no-action letters. Comments on the proposed rule amendment will be accepted by the CFTC for 30 days following its publication in the Federal Register.
- Compliance Weeds: Block Trade Requirements Must Be Followed Strictly; No Chips Off the Old Block Trade Rules Permitted: Block trades are a type of noncompetitive transaction that are permissible under rules of the Commodity Futures Trading Commission if they are executed strictly in accordance with the applicable exchange’s rules. If they are not so executed, the transaction may be a violation of not only the applicable exchange’s rules, but of applicable law and CFTC rules. Typically, exchange block trade rules set forth the minimum qualifications of counterparties, the minimum size of permitted block trades; time reporting requirements, a ban on the entity receiving the customer’s order from trading for itself based on the order information (e.g., no pre-hedging or anticipatory hedging); and a requirement that once a person receives nonpublic information regarding a potential block trade, it cannot trade to take advantage of the information in advance of a public report of the block trade by the exchange. Not all of an exchange’s products may be eligible for block trading, and block trading thresholds may change depending on the time of day. In particular, a trader receiving a request for a block trade, and refusing the transaction, may not use the information for his/her own trading decision, or share the information with another person until a public report of such block trade is published. Likewise, a trader receiving a request for a block trade cannot enter an order for the same or closely related product first, and subsequently execute the block trade. He or she must execute the block trade first, and then may enter a hedging or another type of order for the same or closely related product. This subsequent order may occur as soon as the block trade is executed, even prior to the public report of the trade. However, exchanges' restrictions on using information obtained in pre-execution communications are not meant to interfere with unrelated trading activity of a firm. Rules on block trades may subtly vary in some aspects from exchange to exchange. (Click here to access CME Group’s Market Regulatory Advisory Notice dated November 30, 2015 regarding block trades—which includes the text of its applicable rule 526—and here to access ICE Futures U.S. Block Trades – FAQs dated November 18, 2015—which includes the text of its applicable rule 4.07. Click here to also access ICE Futures U.S. Pre-Execution Communications FAQ dated January 2015.)
For more information, see:
CFTC Proposes a Rule to Permit Foreign Natural Persons to Avoid Fingerprinting:
CME Group Proposes to Toughen Requirements Prohibiting Exchange Access by Persons Subject to Economic Sanctions:
FINRA Will Grade Members on Culture, Supervision and Liquidity Management; BDs Not Managing Spoofing Likely to Get Bad Scores:
FX NDF SEF Approved as SEF by CFTC:
LME Provides 2016 Enforcement Guidelines:
NFA Updates Regulatory Guides to Address New FDM Rules:
Paying Salespersons Salary and Discretionary Bonus Is Misleading When Clients Are Told Payment Is Based on Performance Says SEC in Enforcement Action:
Process for SD and MSP Responses to NFA Requests for Additional Information Revised:
Sentinel Management’s Bank Held by Appellate Court to Have Been on Inquiry Notice of Cash-Management Firm’s Misuse of Customer Funds; Demoted to General Creditor Status:
Steven A. Cohen Barred by SEC From Serving as Hedge Fund Supervisor for Two Years for Alleged Supervisory Failures; No Fine Assessed:
The information in this article is for informational purposes only and is derived from sources believed to be reliable as of January 9, 2016. No representation or warranty is made regarding the accuracy of any statement or information in this article. Also, the information in this article is not intended as a substitute for legal counsel, and is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The impact of the law for any particular situation depends on a variety of factors; therefore, readers of this article should not act upon any information in the article without seeking professional legal counsel. Katten Muchin Rosenman LLP may represent one or more entities mentioned in this article. Quotations attributable to speeches are from published remarks and may not reflect statements actually made.
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