Last week, the federal court hearing the Commodity Futures Trading Commission’s enforcement action against alleged Flash Crash spoofer Navinder Sarao accepted his settlement offer proposed two weeks ago, while a three-judge panel of a federal court of appeals appeared to be sympathetic to Michael Coscia when it heard arguments to overturn his November 2015 conviction for spoofing on November 10. Separately, Mary Jo White announced her imminent resignation as SEC Chair while Timothy Massad, CFTC chairman, was urged to put pens down by K. Michael Conaway, Chairman of the US House of Representatives Committee on Agriculture, regarding CFTC consideration of revised position limits rules, Regulation Automated Trading and the cross-border application of its swap dealer registration requirements. As a result, the following matters are covered in this week’s edition of Bridging the Week:
Because of the US Thanksgiving holiday, there will be no regular Bridging the Week on November 26, 2016. The next edition of Bridging the Week will be on December 5.
The US federal court handling the civil case brought by the Commodity Futures Trading Commission against Navinder Sarao for alleged spoofing activity accepted the settlement agreement jointly submitted by the CFTC and Mr. Sarao two weeks ago. Under the terms of this agreement, Mr. Sarao will pay a fine of over US $25.74 million, disgorge profits of over US $12.87 million and be permanently barred from trading on CFTC-supervised markets, among other sanctions.
The CFTC filed its complaint against Mr. Sarao in April 2015, charging him and his trading company, Nav Sarao Futures Limited PLC, with engaging in spoofing and layering activity involving E-mini S&P futures contracts traded on the Chicago Mercantile Exchange from April 2010 through April 2015 that netted him profits in excess of US $40 million. Mr. Sarao was specifically accused of having engaged in illicit trading that contributed to the May 6, 2010, “Flash Crash.” (The “Flash Crash” refers to events on May 6, when major US-equities indices in the futures and securities markets suddenly declined 5-6 percent in the afternoon in a few minutes before recovering within a similarly short time period.)
Two weeks ago, Mr. Sarao also pleaded guilty to criminal charges brought by the Department of Justice related to the same essential conduct; he awaits sentencing in connection with this matter. (Click here for further background regarding the resolution of Mr. Sarao’s criminal and civil actions in the article, “Alleged Flash Crash Spoofer Pleads Guilty to Criminal Charges and Agrees to Resolve CFTC Civil Complaint by Paying Over $38.6 Million in Penalties” in the November 13, 2016 edition of Bridging the Week.)
Separately, three judges of the US Court of Appeals for the Seventh Circuit heard oral arguments on November 10 related to Michael Coscia’s efforts to set aside his November 2015 criminal conviction on six counts of commodities fraud and six counts of spoofing in connection with his trading activities on CME Group exchanges and ICE Futures Europe from August through October 2011. During his presentation, Mr. Coscia’s counsel principally argued that the provision of law prohibiting spoofing under which Mr. Coscia was prosecuted had not given him adequate notice of what trading activity was precisely prohibited. This was because the relevant provision of law did not define spoofing and, prior to the time of Mr. Coscia’s alleged wrong conduct, the CFTC provided no guidance regarding what constituted prohibited spoofing.
The relevant provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act under which Mr. Coscia was prosecuted first became effective in July 2011, one month prior to the initiation of his alleged wrongful conduct. (Click here to access the relevant anti-spoofing provision, Commodity Exchange Act Sec. 4c(a)(5)(C), 7 US Code Sec. 6c(a)(5)(C).)
The judges hearing the case asked counsel for both Mr. Coscia and the United States to distinguish differences between contingent orders and orders that constituted spoofing, and to opine whether spoofing solely represented an evolution of market practices to address high-speed algorithmic trading. The judges appeared sympathetic to the fact that Mr. Coscia’s conviction was the first prosecution under the new Dodd-Frank provision outlawing spoofing. (Click here for background on Coscia’s sentencing and criminal conviction in the article, “Michael Coscia Sentenced to Three Years’ Imprisonment for Spoofing and Commodity Fraud” in the July 17, 2016, edition of Bridging the Week.)
My View: As I have written before, the anti-spoofing provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act that prohibits trading activity that “is, is of the character of, or is commonly known to the trade as, ‘spoofing’ (bidding or offering with the intent to cancel the bid or offer before execution)” is badly drafted because it uses a term that is assumed to be commonly understood and is followed by a parenthetical that is too broad in scope.
It may seem clear to many what is prohibited by this provision, but by its broad sweep, the provision technically makes illegal relatively ordinary trading conduct that no one – not even the Commodity Futures Trading Commission or any exchange – would likely consider nefarious.
For example, when a trader places a stop-loss order, he or she does not intend for the order to be executed, because presumably that would mean the market is trending in a direction opposite his or her view or expectation. However, he or she would accept an execution if the conditions of the stop-loss order was realized. The CFTC, in its May 28, 2013 Antidisruptive Practices Authority guidance (click here to access) seems to acknowledge this dichotomy. According to the CFTC, “a spoofing violation will not occur when the person’s intent when cancelling a bid or offer before execution was to cancel such bid or offer as part of a legitimate, good-faith attempt to consummate a trade. Thus the Commission interprets the statute to mean that a legitimate, good-faith cancellation or modification of orders (e.g., partially filled orders or properly placed stop-loss orders) would not violate [the spoofing prohibition].”
CME Group, in its interpretation of its rule related to market disruption, goes even further by suggesting there is a difference between intent and hope when placing an order. According to CME, “[m]arket participants may enter stop orders as a means of minimizing potential losses with the hope that the order will not be triggered. However, it must be the intent of the market participant that the order will be executed if the specified condition is met.” (Click here to access CME Group Advisory, RA-1516-5.)
Potentially, every individual that a regulator might seek to prosecute for spoofing will likely hope that some orders might not be executed, but is likely okay for the orders to be executed if they are — i.e., if the specified market conditions are met!
Moreover, in its Advisory, CME Group also provides a number of other examples where the intent of a trader is not necessarily to have all his or her orders executed at the time of order placement, but the consequence is not deemed impermissible spoofing — e.g., placing a quantity larger than a market participant expects to trade in electronic markets subject to a pro rata matching algorithm and placing orders at various price levels throughout an order book solely to gain queue position, and subsequently cancelling those orders as markets change.
Unfortunately, the statute prohibiting spoofing simply has it wrong. There is nothing automatically problematic about all spoofing as now defined under applicable law. Deception, to some extent, is part of smart trading. No trader knowingly reveals all his or her strategy or intent as part of an order placement. Using iceberg orders to disguise order volume is expressly legitimate, for example. As CME Group wrote in a comment letter to the CFTC about what should be deemed illegal spoofing, it is not the intent to cancel orders before execution that is necessarily problematic, it’s “the intent to enter non bona fide orders for the purpose of misleading market participants and exploiting that deception for the spoofing entity’s benefit” (emphasis added; click here to access CME letter to CFTC dated January 3, 2011).
The appellate judges hearing the Coscia appeal spent of lot of time listening to arguments regarding the distinction between hope and intent, the nature of algorithmic trading and how conduct characterized as spoofing might fit into modern markets. Until the spoofing prohibition is clarified to reflect what truly is problematic, it will embrace both legitimate and illegitimate activity, potentially scare away bona fide trading and have a deleterious impact on market liquidity, and inadvertently cause some market participants to run afoul of the law for ordinary order placement activity.
No matter what the outcome of Mr. Coscia’s appeal, the law’s prohibition against spoofing should be amended to not capture commonly accepted legitimate trading activity and to more carefully capture solely what is wrongful conduct.
Compliance Weeds: Firms conducting business abroad often struggle with how to adhere to local custom that incorporates gift giving as a means to demonstrate respect and collegiality while at the same time complying with the strict prohibitions imposed by the FCPA. Unfortunately, under the FCPA, there is not a threshold that provides a safe harbor for gift giving or any other payment (whether in cash or in kind) if the intent is to improperly influence a government official. However, in A Resource Guide to the U.S. Foreign Corrupt Practices Act, a very helpful guide to the FCPA (click here to access), DOJ and SEC staff note that “[i]tems of nominal value, such as cab fare, reasonable meals and entertainment expenses, or company promotional items, are unlikely to improperly influence an official, and, as a result, are not, without more, items that have resulted in enforcement action by DOJ or SEC.” It’s not a bright line test, but it’s something. Also keep in mind, the FCPA applies to all US “domestic concerns” (e.g., all US citizens, nationals, residents and incorporated entities); issuers: and their officers, directors, employees, agents; and shareholders; and certain foreign nationals or entities too while acting in the US.
Compliance Weeds: A wash trade is a type of fictitious trade where a transaction or series of transactions give the appearance of bona fide purchases or sales, but in fact are entered into without the intent to take a bona fide market position or to expose the transactions to market risk or price competition. Specifically, CME Group prohibits as wash trades three types of conduct:
(Keep in mind that the Commodity Exchange Act Sec. 4c(a)(2), 7 U.S. Code Sec. 6c(a)(2)(A)(i) also prohibits transactions that are, are of the character of, or commonly known to the trade as a “wash sale”; click here to access. Other exchanges also have equivalent prohibitions. Click here, e.g., for Wash Sales FAQ of ICE Futures U.S.) According to the CME, a wash trade requires a “wash result,” meaning the purchase and sale of the same instrument at the same price or a similar price for accounts with the same beneficial ownership or for accounts with common beneficial ownership. There is no de minimis for common ownership. In addition, parties’ intent to achieve a wash result may be inferred from evidence of (a) prearrangement or (b) that the orders were structured, entered or executed in a manner that the party(ies) knew or reasonably should have known would produce a wash result. The following would not be considered wash sales:
provided there is no prearrangement and neither party had knowledge of the other’s order or had intent to cross. However, such trades will be subject to heightened scrutiny. Again, a person who executes or accommodates transactions (as well as initiates) that they know or reasonably should know will end in a wash result, will violate the CME Group’s prohibition against wash trades.
And more briefly:
Compliance Weeds: While end users’ attention is rightfully fixated on the new electronic Form 40 and 40S and their new questions, agricultural merchants and hedgers should not forget their obligations to file CFTC Form 204s and 304s as necessary. CFTC Form 204 (Statement of Cash Positions in Grains, Soybeans, Soybean Oil and Soybean Meal) and Parts I and II of Form 304 (Statement of Cash Position in Cotton – Fixed Price Cash Positions) must be filed by any person that holds or controls a position in excess of relevant federal speculative position limits that constitutes a bona fide hedging position under CFTC rules. These documents must be made as of the close of business on the last Friday of the relevant month. Form 204 must be received by the CFTC in Chicago by no later than the third business day following the date of the report, while Form 304 must be received by the Commission in New York by no later than the second business day following the date of the report. Part III of Form 304 (Unfixed Price Cotton “On-Call”) must be filed by any cotton merchant or dealer that holds a so-called reportable position in cotton (i.e., pursuant to large trader reportable levels; click here access CFTC Rule 15.03) regardless of whether or not it constitutes a bona fide hedge. Form 304 (Part III) must be made as of the close of business on Friday every week, and received by the CFTC in New York by no later than the second business day following the date of the report. Form 204s and 304s remain paper forms!
For more information, see:
Bank Settles SEC and FRB Charges That It Violated Federal Law by Hiring Relatives and Friends of Asia-Based Government Officials:
Department of Justice:
Broker-Dealer Sanctioned Over $3.3 Million for Not Making Required Regulator Filings With FINRA and Not Producing Documents in Discovery to Arbitration Claimants:
CFTC Reminds Market Participants of New Form 40 and 71 Requirements:
CME Group Adds New Provisions to Wash Trades Guidance Regarding Indirect Transactions and Pre-Open Activity:
CME Group Amends Block Trade Guidance to Conform With ICE Futures U.S. Guidance; FIA Hosts Exchange Webinar on New Guidances Today:
Federal District Court Approves Flash Crash Spoofer’s US $38 Million Settlement; Federal Appeals Court Appears Sympathetic to Michael Coscia’s Claim That Spoofing Prohibition Is Too Vague:
Five Regulated Clearinghouses Pass CFTC-Administered Stress Tests:
Federal Reserve Imposes Greater Post-Employment Restrictions for Senior Examiners:
Introducing Broker Resolves ICE Futures U.S. Charges Related to Delayed Block Trade Reporting; Another CME Group Member Settles for Faulty ATS:
Ice Futures U.S.:
SEC Chair Announces Imminent Resignation; CFTC Chairman Urged to Put Pens Down on Three Controversial New Initiatives:
SEC Approves Consolidated Audit Trail and Three-Year Phase-In:
FINRA Rule Proposal Requiring Enhanced Disclosure to Retain Clients Regarding Corporate and Agency Fixed Income Securities Approved by SEC:
Tom Sexton Named President and CEO Effective March 1, 2017:
UK FCA Raises Concerns Regarding Weak Price Competition in the Asset Management Sector:
The information in this article is for informational purposes only and is derived from sources believed to be reliable as of November 19, 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.