Bridging the Week by Gary DeWaal


Bridging the Weeks by Gary DeWaal: May 20 – June 7, and June 10, 2019 (O Canada ICO!, Disruptive Trading, New Supervisory Rules; Whose Best Interest?)

Bitcoin Ecosystem    Block Trades and EFRPs    Books and Records    Bridging the Week    Compliance Weeds    Cryptosecurities    Culture and Ethics    Customer Protection    Cybersecurity    Forum Selection    Introducing Brokers    Investment Advisers    Legal Weeds    Managed Money    Manipulation    Memory Lane    My View    Policy and Politics    Supervision    Trade Practices (including Disruptive Trading)    Uncleared Swaps   
Published Date: June 09, 2019

Last week, a Canada-based social media company was sued by the Securities and Exchange Commission for purportedly conducting an unregistered securities offering to United States persons in connection with an initial coin offering of digital tokens. The firm previously asserted in a so-called Wells submission to the SEC that its cryptoassets were not securities, but in any case, purchasers in its ICO would not have expected profits through the efforts of the firm and its agents, but rather solely through secondary market transactions. Separately, in recent prior weeks, the Chicago Mercantile Exchange brought a disciplinary action against a member for liquidating large positions in post-trade settlement periods without considering the impact of the orders on market prices, while the National Futures Association proposed a major overhaul of its guidance on branch office and guaranteed-introducing broker oversight. As a result, the following matters are covered in this week’s edition of Bridging the Weeks:

Video Version:

Article Version

Briefly:

Kik is an Ontario, Canada-based company that developed and promotes a popular internet chat messaging service.

In its complaint filed in a federal court in New York City, the SEC alleged that Kik determined in late 2016 through early 2017 to raise funds through an ICO when it recognized that the popularity of its chat service was declining, and it would run out of cash to fund its operations by late 2017. The firm decided to embark on a new business strategy, involving the development of the “Kin ecosystem” wherein persons could use Kin tokens to purchase goods and services. One director of Kik, termed this “pivot” to a new business model a “hail Mary pass,” claimed the SEC. 

However, said the Commission, at the time of the ICO, the Kin ecosystem, as contemplated, did not exist, and proceeds from the ICO were intended to fund its development. According to the SEC, Kik extensively promoted the ICO as an investment opportunity.

Just prior to the launch of the ICO, the SEC published its so-called “DAO report” on July 25, 2017, in which it said that digital tokens might be securities under US law. (Click here for background in the article,” SEC Declines to Prosecute Issuer of Digital Tokens That It Deems Securities Not Issued in Accordance with US Securities Laws” in the July 26, 2017 edition of Between Bridges.) In response, Kik contacted the Ontario Securities Commission to determine the legality of its offering in Canada. After being advised by OSC that its proposed offer of Kin would constitute the offering of securities, Kik determined to bar Canadians from purchasing Kin in its public sale. The firm did not similarly reach out to the SEC, said the Commission.

The Commission calculated that, through its ICO, as well as a pre-offering (known as a simple agreement for future tokens or “SAFT”) to certain professional investment funds and wealthy investors, Kik raised almost US $100 million, including more than US $55 million from US investors.

The SEC seeks to prohibit Kik from violating US securities law registration requirements, to disgorge funds raised through its ICO and to pay a fine. The agency requested a jury trial for this matter.

Previously, Kik publicized the possibility that it might be sued by the SEC in connection with its Kin ICO. In a so-called “Wells Submission” to the SEC, Kik claimed that Kin was a virtual currency and not subject to US securities laws, and in any case, there was no common enterprise between Kik on the one hand and purchasers of Kin on the other, and no expectation by any Kin purchaser of profits because of the managerial or entrepreneurial efforts of Kik. (Click here for details in the Legal Weeds section of the article, “California Federal Court Reverses Itself and Grants SEC Preliminary Injunction in Purported Cryptoasset Scam” in the February 17, 2019 edition of Bridging the Week.) 

In response to the SEC’s complaint, Kik released a statement in which it said, “We have been expecting this for quite some time, and we welcome the opportunity to fight for the future of crypto in the United States. We hope this case will make it clear that the securities laws should not be applied to a currency used by millions of people in dozens of apps." (Click here to access the full Kik statement.) Recently, Kik launched an initiative called “Defend Crypto” to raise US $5 million to help defend itself in the SEC action through voluntary contributions; through June 7, the firm claimed it had received US $4.4 million. (click here for details).

In other legal and regulatory developments regarding cryptoassets:

My View:Two months ago, the SEC’s Strategic Hub for Innovation and Financial Technology issued guidance on what characteristics a cryptoasset might have that could make it more likely to be deemed an investment contract, and thus a security, under US securities laws. FinHub noted that these characteristics pertain not solely to the “form and terms” of the digital asset itself, but also “the means in which it is offered, sold or resold (which includes secondary market sales).”

In providing its analysis, FinHub utilized the three prongs of the Howey test to determine if an instrument was an investment contract (i.e., an (1) investment of money (2) in a common enterprise with the (3) reasonable expectation of profits through efforts of others), and keyed in on the last prong. (Click here to access the Supreme Court’s 1946 decision in SEC v. W.J. Howey.)

(Click here for background on the FinHub’s guidance in the article “SEC Staff Outlines Characteristics of Cryptoassets That Could Cause Them to Be Regarded as Securities” in the April 7, 2019 edition of Bridging the Week.)

In its complaint against Kik, the SEC tracked many of the themes in its April 2019 guidance in explaining why the Kin ICO constituted an offer of securities. The Commission meticulously laid out the basis for its view that investors who participated in the Kin ICO were investing money in a common enterprise and did so because they believed they would profit through the appreciation in the price of Kin as a result of the efforts of Kik and its agents in developing the Kin ecosystem and promoting Kin. 

Internally at Kik, said the SEC, employees were told how the Kin ICO would be a “new way” to raise capital. Externally, noted the SEC, Kik and its agents emphasized to prospective Kin purchasers the opportunity to profit alongside other Kin investors as well as Kik itself as the Kin ecosystem was developed and matured. Critically, at the time of the ICO, said the SEC, the sole feature of the Kin ecosystem was a minimum value product in the form of cartoon stickers that was intended to enhance the Kik Messenger experience. Proceeds from the ICO were intended to fund the Kin ecosystem development.

Although Kik has not yet formally answered the SEC’s complaint, it previewed its response in a Wells Submission filed with the SEC last December as well as in a formal statement issued after the Commission’s filing.  Generally, Kik believes the SEC has stretched Howey too broadly, but in any case, Kin is not a security; purchasers did not invest funds in a common enterprise; and purchasers did not have a reasonable expectation of profits through the efforts of Kik and its agents. Profits per Kik were to be obtained through ordinary market forces.

Notwithstanding Kik’s apparent arguments, if the SEC can prove the facts it pleaded, Kik will have an uphill battle. Howey – like it or not – is a long established Supreme Court precedent and it will be very challenging for Kik to convince a jury that what looks like a security offering, walks like a security offering and sounds like a security offering was anything else but a security offering. 

That being said, it is not beyond possibility that a court could hold that a financial instrument that conveys no rights, directly or indirectly, to income from a corporation and where a holder has no claims of any kind if the corporation files for bankruptcy is not a security. Kik’s argument that any profits achieved through ordinary secondary market trading would not have been attributable to Kik or its agents has some technical, intellectual appeal; however, it likely ignores the impact of the firm’s alleged purposeful publicity on market sentiment.

Separately, Jonathan Alexander, a former trader for Macquarie Energy LLC, agreed to pay a fine of US $85,000 to ICE Futures U.S. and incur a nine-month trading suspension on all IFUS markets for possibly engaging in manipulative and disruptive practices to cause market participants to trade at artificial prices. According to IFUS, on various days between August 5 and 18, 2016, Mr. Alexander entered offers in the ERCOT North 345 KV Real-Time Off-PeakDaily Fixed Price futures contract at prices more consistent with the historical prices of the ERCOT North 345 KV Real-Time Peak Daily Fixed Price futures contract. 

As a result of the manner in which Mr. Alexander placed  his offers, some market participants believed there were favorable buying opportunities in the Peak futures and that they were purchasing Peak futures contracts. However, in fact, the market participants were transacting in the Off-Peak futures and subsequently reported the trades as an error and received substantial adjustments. According to IFUS, Mr. Alexander engaged in this behavior “after he unknowingly fell victim to the same circumstances he then caused to occur. [He] intended to provide the point that he was dissatisfied with the price adjustment [he received from IFUS] after executing a series of trades in a wrong market.” Macquarie Energy also agreed to pay a fine of US $250,000 to resolve IFUS charges related to Mr. Alexander’s conduct.

Compliance Weeds: It’s not just spoofing that might constitute disruptive trading.

In March 2017, Saxo Bank A/S, a member firm, agreed to pay an aggregate fine of US $190,000 to the CBOT and the CME to resolve two disciplinary actions brought against it for the way it liquidated futures positions of its customers that were under-margined. According to the exchanges, on multiple dates between October 2014 and March 2015, Saxo employed a liquidation algorithm that automatically entered market orders for the entire amount of an under-margined customer’s positions. The exchanges said Saxo Bank did so without considering market conditions and therefore violated its disruptive trading practices rule. (Click here for background in the article “CME Group Settles Disciplinary Action Alleging That Automatic Liquidation of Under-Margined Customers Positions by Non-US Futures Broker Constituted Disruptive Trading” in the March 20, 2017 edition of Bridging the Week.)

Persons entering orders on CME Group and other exchanges must be mindful of the potential impact of their orders on the marketplace and avoid actionable or nonactionable messages that are likely to have a disruptive impact on the marketplace. This appears to be particularly the case where the same person or entity places similar type orders with similar deleterious impact on the market over multiple days.

Under Regulation Best Interest, a broker, dealer or natural person associated with a broker or dealer who makes a recommendation to a retail customer of any securities transaction or investment strategy involving securities must act in the best interest of the customer ahead of  the financial or other interests of the broker, dealer or AP. To satisfy this requirement, broker-dealers must satisfy certain enumerated disclosure, care, conflict of interest and compliance obligations.

Commissioner Robert Jackson dissented from the SEC’s vote to pass Regulation Best Interest, saying that “[r]ather than requiring Wall Street to put investors first, today’s rules retain a muddled standard that exposes millions of Americans to the costs of conflicted advice.” Chairman Jay Clayton on the other hand praised the new SEC initiatives, noting that Regulation Best Interest “goes significantly beyond existing broker-dealer obligations”; the Relationship Summary is an “improvement” over existing disclosures; and the fiduciary duty interpretation does not weaken existing standards; instead it “reflects how the Commission and its staff have applied and enforced the law in this area, and inspected for compliance for decades.”

By June 30, 2020, broker-dealers must begin complying with Regulation Best Interest and broker-dealers and investment advisors must prepare and deliver to retail investors Relationship Summaries. The new interpretations will be effective upon publication in the Federal Register.

Memory Lane: Unlike in the securities industry, there are generally no suitability requirements in the futures industry and there is no insurance on customer accounts.

Early in its history, the Commodity Futures Trading Commission considered adoption of a suitability rule – CFTC proposed rule 166.2. Under the proposed rule, Commission registrants would not have been permitted to make a recommendation to buy or sell a futures contract or to engage in a discretionary trade for any customer “unless the registrant had reason to believe the recommendation or trade was suitable for the customer in light of his financial condition.” The Commission declined to adopt proposed rule 166.2 “because the Commission was unable …to formulate meaningful standards or universal application.” (Click here for further background in the 1978 Federal Register discussion regarding the CFTC’s adoption of Part 166 customer protection rules at pg. 31888.)

In 1986, the National Futures Association also declined to adopt a suitability rule for future commission merchants and instead mandated they issue risk disclosure statements to customers and obtain certain information from them (click here to access NFA Rule 2-30). According to NFA, “futures contracts in general are recognized as highly volatile instruments. It therefore makes little sense to presume that a certain futures trade may be appropriate for a customer while others are not. [As a result,] the customer is in the best interest to determine the suitability of futures trading if the customer receives an understandable disclosure of risks from a futures professional who ‘knows the customer’.” (Click here for further background in NFA Interpretive Notice 9004.)

In 2009, the Financial Industry Regulatory Authority proposed extending suitability requirements of broker-dealers for securities to recommendations for all financial products, including futures for combined broker-dealers/FCMs. In addition to arguing against the proposal on the grounds of CFTC preemption, the Futures Industry Association railed against FINRA’s proposal on the grounds that “there is a definitive difference in the various types of products overseen by the SEC and those overseen by the CFTC. Securities and futures products differ in that, while there may be an endless variation of different types of securities with varying investment strategies… futures contracts are inherently standardized with only two traditional types of investors – hedgers and speculators – each of whom trade futures with the investment strategy of risk management and capital gains.” FINRA’s proposal was not adopted. (Click here to review FIA’s June 29, 2009 letter to FINRA re: “Proposed Consolidated FINRA Rules Governing Suitability and Know-Your-Customer Obligations.”)

Notwithstanding, FCMs that are not members of FINRA must ensure that recommendations to customers to buy or sell securities futures or to engage in a trading strategy regarding such products are “not unsuitable” (see NFA Rule 2-30(j)(4)).

Separately, in 2013, CME Group, the FIA, the Institute for Financial Markets and NFA commissioned a study by Compass Lexecon regarding the feasibility of adopting an insurance regime for the US futures industry. Among other alternatives, a model was considered that would offer “the same kind of protection” that at the time was provided to securities investors by the Securities Investor Protection Corporation – up to US $250,000 to every customer of every US FCM to cover losses from the failure of under-segregated FCMs. Under the proposal, the insurance would be funded by FCMs paying 0.5 percent of their annual gross revenue up to a targeted funding level of US $2.5 billion. The study concluded, however, that the proposal was not feasible as it would take 55 years to reach the targeted level, assuming no interim losses. (Click here to access the futures industry-commissioned insurance study.)

For advance due diligence review of potential branches and G-IBs, members will be required to consider the nature of the business to be conducted in the location and the background and employment history of all personnel to ensure they are qualified,  as well as to ensure that at least one person will be able to track Commodity Futures Trading Commission and NFA regulatory developments. As a result of its due diligence, the member should confirm that it wants to establish the branch office or G-IB relationship and determine the scope of the supervisory oversight it should apply on an ongoing basis.

For ongoing supervision, members must implement both routine supervision and surveillance to identify and deal with potential issues as they arise and annual inspections that are meant to be more comprehensive and detailed. A firm’s policies and procedures must expressly note when it will notify NFA and/or other “appropriate regulators” of “significant findings” including, but not limited to, fraud or customer harm. Qualified personnel must perform the routine surveillance and inspections, although third-party vendors may be retained to assist in such activities; however, in such instance the member must perform due diligence to confirm the third-party vendor is qualified. Supervisory procedures for branches and G-IBs must address registration, hiring, promotional material, sales practices, customer information and risk disclosure anti-money laundering, handling of customer funds, customer order procedures, account activity, discretionary accounts, proprietary accounts, bunched orders, customer complaints and information system security programs. As before, members must train their personnel regarding applicable industry rules and regulations and ensure they satisfy ethics requirements. (Click here to access NFA Interpretive Notice 9051.)

The proposed NFA guidance replaces guidance currently associated with NFA Rule 2-9 (click here to access existing NFA Interpretive Notice 9019). NFA submitted its proposed rule change to the CFTC on May 21 subject to a 10-day review schedule. Typically, however, NFA requires compliance with new rules only after a reasonable time which is preceded by member outreach and education.

Compliance Weeds: Importantly, NFA’s revised guidance, like its existing guidance regarding supervision of branch offices and G-IBs, applies to all members – although provisions related to G-IBs are solely meaningful to FCMs and Forex Dealer Members. Accordingly all members must review the revised guidance to assess which provisions might apply to them and to revise their policies and procedures to reflect new requirements. Moreover, all members should be aware of NFA’s expectation that they will escalate to it “and/or” other regulators “significant findings” identified during routine supervision or annual inspections. These might include findings related to fraud or customer harm, but are not expressly limited. When revising their policies and procedures, members should not solely cut and paste NFA’s requirements, but adapt them specifically to their own business operations. Moreover, all policies and procedures should be periodically reviewed and updated to reflect amended regulatory requirements and changed business operations.

According to NFA, during the relevant  time, Mr. Webb engaged in at least 13 block trades for customers of Classic where, after confirming an agreed block transaction at a specific price, Mr. Webb entered into the precise futures trade at a better price for a company he owned, MDW Capital LLC. Without the customer’s permission, Mr. Webb subsequently entered into the agreed block trade between MDW on one side, and the customer on the other side, and liquidated the offsetting futures positions at MDW for a profit. NFA reviewed other trading records of MDW and believed Mr. Webb’s illicit activity occurred beyond the May through September 2015 time period.

Separately, from January 2012 through August 27, 2015, Classic had a malfunction in its telephone taping system that precluded recordings. Pursuant to CFTC rules, however, since December 2013, the firm was required to record all oral communications made or received that led to a commodity interest transaction and to retain such recordings for one year (click here to access CFTC Rule 1.35(a)(1)(iii)). According to NFA, Ms. Webb claimed she learned of Classic’s tape-recording breakdown on August 18, 2015 when ICE Futures U.S. made a request for specific telephone conversations during a parallel investigation. However, NFA said that, pursuant to email it reviewed, Ms. Webb and Classic were aware of the telephone recording breakdown since at least February 2015. Ms. Webb never advised NFA of this problem during pre-NFA exam discussions in August and September 2015 or after fieldwork commenced at Classic in connection with an NFA examination on October 12, 2015.

Classic agreed to pay a fine of US $200,000 to resolve NFA’s complaint, while Mr. Webb agreed to be suspended from NFA associate membership through January 3, 2022 in accordance with the terms of an unpublished side letter.  Classic and Ms. Webb agreed to adopt and implement recommendations also made in the unpublished side letter.

Legal Weeds: A mystery solved!

In December 2016, four respondents in IFUS-linked disciplinary actions – Classic, MDW, Mr. Webb, and Lee Tippett, a co-worker of Mr. Webb's – agreed to settle their exchange matters by paying sanctions in excess of $1.15 million; however, from the published decisions, it was unclear precisely what was the possible overall wrongful conduct that gave rise to the sanctions. As a result of publication of the NFA proceeding, this unclarity is no more.

In the IFUS disciplinary action associated with the largest monetary sanction, Mr. Webb agreed to pay a fine of US $503,627 and disgorge profits of US $303,627, as well as incur a five-year trading ban on IFUS for possibly engaging in 52 fictitious transactions and permitting his electronic trading system ID to be used by Mr. Tippett. 

The exchange also charged Mr. Webb with possibly committing or attempting to commit an unspecified fraudulent action on the exchange. In addition, Mr. Tippett agreed to pay a fine of US $100,000 and serve a nine-month exchange trading ban for possibly executing 25 fictitious transactions and using Mr. Webb’s exchange trading system identification. 

In addition, MDW agreed to be permanently barred from all trading on IFUS for possibly engaging in practices “inconsistent with just and equitable principles of trade and conduct detrimental to the best interests of the Exchange,” while Classic Energy LLC consented to paying a fine of US $250,000 and adding compliance staff. (Click here for further details regarding the IFUS disciplinary actions in the article “Defendants in Linked ICE Future U.S. Disciplinary Actions Agree to Pay Collective Sanctions in Excess of US $1.15 Million to Resolve Diverse Charges” in the December 18, 2016 edition of Bridging the Week.) 

More Briefly:

At the time of account opening, all defendants except two had signed an agreement with FCStone whereby they agreed that all claims relating to their account would be settled by arbitration before the NFA or at the contract market where the disputed transaction was executed or could have been executed. Notwithstanding, after defendants sustained significant losses in their accounts trading futures in November 2018 they initiated an arbitration against the FCM before FINRA. The defendants argued that because FCStone was a combined FCM and broker-dealer as well as a member of FINRA, it was subject to a FINRA rule that requires members to arbitrate disputes between customers and themselves before FINRA. (Click here to access FINRA Rule 12200.)  FCStone argued that defendants were not customers for purpose of this rule. “Customers,” claimed FCStone meant customers trading securities regulated by the Securities and Exchange Commission, and not commodity-related financial products under the oversight of the Commodity Futures Trading Commission. The court agreed with this view and ordered all defendants except two persons (who did not sign an arbitration agreement with FCStone) to submit their arbitration before NFA.

OCIE indicated that a “configuration management program that includes policies and procedures governing data classification, vendor oversight, and security features will help to mitigate the risks incurred when implementing on-premise or cloud-based network storage solutions.” Among other things, OCIE noted good practices it has observed included adoption of policies and procedures governing installation, ongoing maintenance and regular review of network storage solutions; guidelines for security controls and minimum configuration standards; and vendor management policies and procedures that require, among other things, regular installation of software patches and hardware updates.

Follow-Up:

For further information

ASIC Issues Advisory on ICOs and Cryptoasset Trading Platforms:
https://asic.gov.au/regulatory-resources/digital-transformation/initial-coin-offerings-and-crypto-assets/

CFTC’s Inspection Unit Finds Security Weaknesses in Agency’s Surveillance System Containing Confidential Market and Privacy Information:
https://www.cftc.gov/media/2076/OIG_CFTCDataGovernanceISS/download

CME Sanctions Trader for Liquidating Large Positions Without Considering Market Impact:

CME:

IFUS:

European Central Bank Says Risks of Cryptoassets Minimal on Monetary Policy, Payments and Market Infrastructures:
https://www.ecb.europa.eu/pub/pdf/scpops/ecb.op223~3ce14e986c.en.pdf

FCM Prevails in Federal Court to Have Customer Dispute Heard Before NFA, Not FINRA Arbitration Forum:
/ckfinder/userfiles/files/Intl%20FCStone.pdf

Final Decision on Bitcoin ETF Again Delayed by SEC:
https://cdn.crowdfundinsider.com/wp-content/uploads/2019/05/SEC-CBOE-VanEck-SolidX-Bitcoin-Trust-5.2.0.1934-85896.pdf

FSB and IOSCO Express Concerns About Growing International Market Fragmentation:

IOSCO Solicits Feedback on Proposed Key Considerations for Regulators’ Evaluation of Cryptoasset Trading Platforms:
https://www.iosco.org/news/pdf/IOSCONEWS530.pdf

LME Follows IFUS Lead With Futures Trading Speed Bumps:
19 165 Technical change to LMEselect FIX message processing for the LMEprecious market (69.36 KB)

Misusing Client Block Trades’ Information and Phone Recording Breakdown Result in NFA Sanctions Against Multiple Parties:

New CFTC Chairman Confirmed by Senate:
https://www.congress.gov/nomination/116th-congress/18

NFA Proposes Overhaul of Requirements for Supervision of Branch Offices and Guaranteed IBs:
https://www.nfa.futures.org/news/PDF/CFTC/Interp-Notice-CR%202-9-Supervision-Branch-Offices-GIBs-052119.pdf

SEC Adopts New Regulation to Ensure Retail Customers’ Best Interest Takes Priority Over Broker-Dealer’s:

SEC Kicks Canada-Based ICO Issuer; Claims It Conducted Unregistered Securities Offering to US Persons:
https://www.sec.gov/litigation/complaints/2019/comp-pr2019-87.pdf

SEC OCIE Summarizes Observed Best Practices for Storage of Customers’ Electronic Records by Broker Dealers and Investment Advisors:
https://www.sec.gov/files/OCIE%20Risk%20Alert%20-%20Network%20Storage.pdf

Where’s the CFTC v. Agricultural Food Giants’ Purported Manipulation Settlement?:
/ckfinder/userfiles/files/CFTC%20v_%20Kraft%20Continuation.pdf

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of June 8, 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 Muchin or any of its partners or employees.


© 2019 Katten Muchin Rosenman and Gary DeWaal. All Rights Reserved.