Bridging the Week by Gary DeWaal


Bridging the Week by Gary DeWaal: January 25 – 29 and February 1, 2016 (Money Market Funds; Independent IBs; FERC Jurisdiction; Pre-Execution Communications)

Bridging the Week    Compliance Weeds    Customer Protection    Federal Energy Regulatory Commission    Manipulation    Trade Practices (including Disruptive Trading)   
Published Date: January 31, 2016

Last week, one bank was successful in having a lawsuit against it dismissed alleging that it contributed to the demise of a futures commission merchant by prompting the FCM to invest customer funds in an ineligible investment. Also, the US Supreme Court upheld the authority of the Federal Energy Regulatory Commission to enact a regulation that encouraged wholesale market operators to pay electricity consumers not to use electricity during peak times. The Court held that, although these transactions impacted retail sales, they were not prohibited retail transactions within states' exclusive authority. As a result, the following matters are covered in this week’s edition of Bridging the Week:

  • Bank Wins Dismissal of Lawsuit Claiming It Misled FCM About the Appropriateness of an Investment for Customer Segregated Funds (includes Compliance Weeds);
  • Independent IB Agrees to Withdraw From Registration Following NFA Complaint That It Failed to Cooperate and Meet Minimum Financial Requirements;
  • US Supreme Court Upholds FERC’s Jurisdiction to Take Actions That Impact Retail Electricity Sales;
  • CME Group Updates Its Pre-Execution Communication Rule to Reflect New Committed Crosses (includes Compliance Weeds);
  • Purposeful Large Non-Execution to Execution of Orders Ratio? – Speak to Your Lawyers Warns CFTC Chairman; and more.

Video Version:

Article Version:

Briefly:

  • Bank Wins Dismissal of Lawsuit Claiming It Misled FCM About the Appropriateness of an Investment for Customer Segregated Funds: A lawsuit against JPMorgan Chase & Co., and various affiliates and employees (collectively, “JPMorgan”), claiming they improperly induced MBF Clearing Corp, a former futures commission merchant, to improperly invest customer funds, was dismissed last week by a New York State trial court judge. MBF and an affiliated company had claimed that, in 2008, JPMorgan encouraged the firm to invest customer funds in a proprietary fund – the J.P. Morgan U.S. Government Money Market Fund. However, subsequently, in March 2012, the Commodity Futures Trading Commission brought an enforcement action against MBF claiming the firm’s investment of customer funds in the USG Fund violated CFTC rules. This was because, as expressly stated in the USG Fund’s prospectus, redemption requests for the USG Fund could take up to seven days, and even longer under certain circumstances. However, under the applicable CFTC rule, FCMs may only invest customer funds in money market funds that meet certain conditions, including that redemption requests are legally required to be met by the next business day following a request. (Click here to access the CFTC complaint against MBF.) MBF was also charged with depositing customer funds with JPMorgan without obtaining a proper acknowledgment letter from the bank and for not ensuring its accounts at JPMorgan were properly titled as reflecting customer funds. MBF settled its CFTC action in November 2012 by payment of a fine of US $650,000. (Click here to access the relevant Consent Order.) MBF brought this action against JPMorgan alleging the bank wrongfully solicited MBF to invest customer funds in an unauthorized vehicle, and failed, after an initial period, to reflect MBF’s investment as being on behalf of its customers on account statements. MBF sought damages in excess of US $50 million for projected lost profits, claiming that the bank’s wrongful actions led to the subsequent CFTC complaint against it, and caused the firm to have to withdraw its FCM license and become solely an introducing broker. The judge – The Hon. Jeffrey K. Oing of the Supreme Court of the State of New York – granted JPMorgan’s request to dismiss MBF’s lawsuit, saying the plaintiffs “failed to allege sufficient facts to support justifiable, reasonable reliance, particularly where documentary proof indicates that plaintiffs undertook due diligence.”

Compliance Weeds: Under law, CFTC-registered futures commission merchants may invest customer funds in certain government obligations. The CFTC expanded the list of permitted investments in 2000 to add money market funds among other authorized investments. However, investments in MMFs are subject to strict conditions, including that redemption requests must legally be honored by no later than the business day following a request. After the collapse of MF Global in October 2011, the CFTC restricted its previously expanded list of permissible investments of customer funds. Among other things, the version of the relevant rule now in effect precludes FCMs from investing customer funds in non-US government guaranteed corporate obligations and foreign sovereign securities, and engaging in repurchase transactions with affiliated companies. In addition, the revised rule imposes concentration limits for certain asset classes (e.g., the maximum percentage an FCM can hold of that asset type compared to its total customer funds held in segregation) and has strict issuer-based concentration limits. (Click here to access the current version of CFTC Rule 1.25.) The CFTC considers that its customer funds' investment requirements must be adhered to at all times and has already brought enforcement actions against FCMs for their failure to meticulously comply with its new post-MF Global requirements. (Click here for further information on the CFTC’s investment rule for customer funds in the article “CFTC Adopts Final Rule on Investment of Customer Funds” in the December 9, 2011 edition of Corporate & Financial Weekly Digest by Katten Muchin Rosenman LLP. Click here and here for prior editions of Bridging the Week containing articles related to CFTC enforcement actions against FCMs for not meeting new post-MF Global collapse customer funds’ investment requirements.)

  • Independent IB Agrees to Withdraw From Registration Following NFA Complaint That It Failed to Cooperate and Meet Minimum Financial Requirements: CC Trading Company LLC agreed never to apply for membership in the National Futures Association or act as a principal for an NFA member in order to resolve an NFA complaint filed against it last year. CC Trading was previously registered with the Commodity Futures Trading Commission as an introducing broker and a member of NFA. In the complaint against CC Trading, NFA charged that the firm failed to meet minimum financial requirements for an independent IB (i.e., US $45,000) and failed to cooperate with the NFA, among other violations. NFA also charged Christopher Craddock, a principal of CC Trading, with the same offenses. Mr. Craddock settled his charges too by consenting not to apply for NFA membership or associate membership, or as principal of any NFA member, for two years. If after such time he applies for NFA membership, he agreed to pay a US $25,000 fine. CC Trading was previously cited for not complying with the minimum financial requirements for an IB by the NFA in 2011. The firm settled that matter by payment of a fine of US $15,000. As alleged by the NFA, during an exam to ensure that CC Trading was subsequently compliant, NFA learned that the firm was not. NFA said it was this subsequent failure and alleged behavior by the firm and Mr. Craddock that gave rise to the current legal action.
     
  • US Supreme Court Upholds FERC’s Jurisdiction to Take Actions That Impact Retail Electricity Sales: The United States Supreme Court upheld the authority of the Federal Energy Regulatory Commission to adopt a regulation that might indirectly affect the quantity or terms of retail electricity sales because the intended and direct impact was on wholesale electricity markets. The relevant rule was designed to encourage a practice called “demand-response” by which operators of wholesale markets pay electricity consumers not to use electricity at certain high peak times (click here to access FERC Rule 35.28(g)(1)(v)). By doing so, demand for electricity is theoretically reduced, and higher use of electricity that might degrade electricity grids (and potentially cause brown-outs or even blackouts) is avoided. Under applicable law, FERC has the authority to regulate “the sale of electric energy at wholesale in interstate commerce,” but leaves “any other sale of electric energy,” to the states’ exclusive oversight, including retail sales. A federal appeals court previously ruled that FERC infringed state authority when it adopted its demand-response rule. The FERC rule was challenged by the Electric Power Supply Association – a national trade association for power suppliers. In ruling for FERC, in a 6-2 decision authored by the Hon. Elena Kagan, the Court held that the agency’s wholesale demand-response rule directly affected wholesale price. There may be an impact on retail prices, said the Court, but that does not render such rules impermissible. According to the Court, “[i]t is a fact of economic life that the wholesale and retail markets in electricity, as in every other known product, are not hermetically sealed from each other. To the contrary, transactions that occur on the wholesale market have natural consequences at the retail level. And so too, of necessity will FERC’s regulation of those wholesale matters.” The dissenting opinion, written by the Hon. Antonin Scalia, noted that, under applicable law, wholesale energy sales are defined as “a sale of electric energy to any person for resale.” According to Judge Scalia, since demand-response participants consume electricity themselves rather than resell it, FERC’s rule encouraging demand-response is not aimed at electricity sales at wholesale and is thus unauthorized.
     
  • CME Group Updates Its Pre-Execution Communication Rule to Reflect New Committed Crosses: CME Group proposed amendments to its rule regarding pre-execution communications to add a new procedure to effectuate lawful cross trades following such communications (click here to access CME Rule 539C). The new mechanism is termed a “committed cross” and, absent objection by the Commodity Futures Trading Commission, will be required for all Chicago Mercantile Exchange and Chicago Board of Trade interest rate, equity and foreign exchange options contracts traded on Globex beginning trade date April 11, 2016. Other contracts will be subject to existing cross trade protocols. Unlike now, no request for a quote (RFQ) must be issued prior to a request for a cross (RFC) for a C-Cross transaction. In a C-Cross transaction, following a pre-execution communication, the submitter must “definitively” submit the proposed cross order to the Globex marketplace through a request for quote, which will tell market participants that a cross will occur after a certain time has passed (typically five seconds for options) unless it is earlier matched against existing liquidity. At the time it implements C-Cross functionality, CME Group will also introduce for interest rate and FX options only (but not equity options) a “Better Price Match Allocation” protocol to ensure that, where a cross trade request represents a new best bid or offer at the time of order placement, and during the time of pendency no better price for the buy or sell is entered, at least a certain percentage of the order will be crossed. Initially this percentage will be 20 percent.

Compliance Weeds: In general, for approved contracts, CME Group permits pre-execution communications to facilitate trading subject to strict requirements. Among these requirements are that the party on whose behalf a communication is being made previously must have consented to such communication and that no person involved in pre-trade communications may take advantage of information conveyed except to facilitate the relevant trade. Unfortunately, CME Group rules regarding cross trades vary by product and by futures and options. Even the mechanical steps for executing a cross trade following a conversation varies. There are Globex Crosses, Agency Crosses, and RFQ and RFC Crosses – and now Committed Crosses too. However, despite the complexity, the consequences of getting it wrong can be severe, resulting in not only potential CME Group sanctions, but possible sanctions by the Commodity Futures Trading Commission too. (Click here to access the article “CFTC Fines FirstRand Bank for Unlawful Pre-Execution Discussions Related to Soybean Futures Trades” in the September 1, 2014 edition of Bridging the Week.) Most simply, all non-competitive trades are strictly prohibited under CFTC rules, and any violation of a CME Group rule regarding pre-execution communications, could also be deemed a violation of this CFTC requirement. Pre-execution communication rules of other designated contract markets are similar but contain important differences from CME Group requirements (click here to access the “Pre-Execution Communication FAQ” of ICE Futures U.S. (dated January 2015) and here to access guidance with respect to executing cross orders on Nasdaq Futures, Inc.). The CME Group advisory notice that was issued in connection with its revised rule contains a very helpful matrix that sets forth the different types of cross-trade protocols that must be followed for futures and options and different products (click here to access).

  • Purposeful Large Non-Execution to Execution of Orders Ratio? – Speak to Your Lawyers Warns CFTC Chairman: Timothy Massad, Chairman of the Commodity Futures Trading Commission, warned attendees at the annual P.R.I.M.E Financial conference in Amsterdam that trading firms should likely seek legal assistance if they purposely had a very high ratio of unfilled to filled orders. According to Mr. Massad, “[i[n a recent case, a defendant entered over 460,000 orders, but consummated only 371 trades. … [I]f your trading firm is entering a lot of orders without the intention to consummate, you should probably go talk to your lawyers.” In a wide ranging speech to members of this organization – whose stated purpose is to “resolve, and to assist judicial systems in the resolution of, disputes concerning complex financial transactions” – Mr. Massad also addressed initiatives by the CFTC to help ensure clearinghouses’ resiliency, the supplemental leverage ratio (“SLR”) and improving swap data reporting. As he has before, Mr. Massad supported banking regulators’ steps to increase financial institutions’ limits on liabilities compared to assets through the SLR. However, he objected that, in connection with derivatives, banking regulators to date have not permitted banks to offset banks’ potential exposure to clearinghouses by collateral they post in computing their SLR. According to Mr. Massad, “the way the SLR measures potential future exposure could have a significant, detrimental effect on clearing, and in turn, on clearinghouse resiliency. A large banking institution will look at the costs of regulation on each aspect of its business. And if some clearing members choose to limit customers, or get out of the clearing business altogether, that may make it harder to deal with the next time a clearing member defaults.”

And more briefly:

  • Six London LIBOR Traders Acquitted by UK Jury: Six individual defendants prosecuted by the UK Serious Fraud Office for violations of law related to their alleged involvement with LIBOR manipulation schemes were found not guilty by a jury last week. All had been charged specifically with conspiring with Tom Hayes – who previously had been convicted in connection with his role in the LIBOR manipulation schemes – to illegally influence the submission of panel banks in the Yen LIBOR setting process. (Click here for details on Mr. Hayes’ conviction in the article “First LIBOR Defendant, Tom Hayes, Found Guilty of Conspiracy to Defraud and Sentenced to 14 Years in Prison” in the August 14, 2015 edition of Bridging the Week.)
     
  • NFA Updates NFA Regulatory Requirements Guidance: The National Futures Association updated its NFA Regulatory Requirements for FCMs, IBs, CPOs and CTAs brochure. In general, changes reflect recent amendments to NFA’s financial requirements that conformed NFA’s rules to requirements in the CFTC’s recently enacted rule changes to enhance customer protections. (Click here to access an overview of the CFTC rule changes in the article “CFTC Adopts More Stringent Customer Funds’ Protection Rules” in the October 30, 2013 edition of Between Bridges.”)

For more information, see:

Bank Wins Dismissal of Lawsuit Claiming It Misled FCM About the Appropriateness of an Investment for Customer Segregated Funds:

Amended Complaint:
MBF Complaint JPM.pdf
Motion to Dismiss:
MBF-JPM Brief Support Motion to Dismiss.pdf
Decision:
MBF Decision JPM Motion to Dismiss.pdf

CME Group Updates Its Pre-Execution Communication Rule to Reflect New Committed Crosses:
http://www.cmegroup.com/tools-information/lookups/advisories/market-regulation/files/RA1602-5.pdf

Independent IB Agrees to Withdraw From Registration Following NFA Complaint That It Failed to Cooperate and Meet Minimum Financial Requirements:

Complaint:
http://www.nfa.futures.org/basicnet/CaseDocument.aspx?seqnum=4116
Decision:
http://www.nfa.futures.org/basicnet/CaseDocument.aspx?seqnum=4287
http://www.nfa.futures.org/basicnet/CaseDocument.aspx?seqnum=4288

NFA Updates NFA Regulatory Requirements Guidance:
https://www.nfa.futures.org/NFA-compliance/publication-library/regulatory-requirements-guide.pdf

Purposeful Large Non-Execution to Execution of Orders Ratio? — Speak to Your Lawyers Warns CFTC Chairman:
http://www.cftc.gov/PressRoom/SpeechesTestimony/opamassad-38

Six London LIBOR Traders Acquitted by UK Jury:
https://www.sfo.gov.uk/2016/01/29/libor-defendants-acquitted-update/

US Supreme Court Upholds FERC’s Jurisdiction to Take Actions That Impact Retail Electricity Sales:
http://www.supremecourt.gov/opinions/15pdf/14-840diff_l6gn.pdf

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of January 30, 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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