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Bridging the Week by Gary DeWaal: May 9 - 13 and May 16, 2016 (Personal Liability; Rogue Trader; Hubris Risk; Spoofing)

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Published Date: May 15, 2016

Last week a futures commission merchant and its controller were both named in an enforcement action by the Commodity Futures Trading Commission for their alleged failure to immediately file a notice with the CFTC when, for one night, the firm failed to have sufficient customer funds in segregation and enough of its own funds in a customer segregated account as a buffer, following a clerical error. In addition, the principal financial regulator of Dubai barred a rogue trader who hid approximately US $11 million of trading losses through position mismarking, while the incoming head of the UK Financial Conduct Authority identified “hubris risk” as a dangerous risk firms can only mitigate through adoption of a good culture. As a result, the following matters are covered in this week’s edition of Bridging the Week:

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Controller of FCM Named in CFTC Complaint, Along with Firm, for Failure to Timely Notify Commission of Segregation Breach:

Cunningham Commodities, LLC, a futures commission merchant registered with the Commodity Futures Trading Commission, and Salvatore Russo, its controller and head accountant, settled CFTC administrative charges for allegedly not immediately notifying the Commission when Mr. Russo recognized the firm’s failure one night to hold (1) its required minimum amount of funds in its segregated customer account and (2) its own targeted amount of its own funds in its customer segregated account as a buffer. The firm's segregated funds inadequacy apparently was caused by a clerical error.

The firm also settled charges related to its alleged failure to file with the Commission required reports of certain open positions for large traders for almost six months on one occasion, and two weeks on another occasion.

The respondents both agreed to pay one fine of US $150,000 to resolve the CFTC’s enforcement action.

According to the CFTC, on March 10, 2014, a staff accountant failed to transfer US $5 million in loaned funds from Cunningham’s house account to its customer segregated account. As a result, the firm incurred a customer segregated funds’ deficiency in excess of US $3.4 million, and failed to maintain the firm’s targeted amounts of its own funds in segregation (US $600,000) in excess of the firm’s minimum customer segregated funds’ requirement. (Under applicable CFTC rules, FCMs are required to maintain a certain minimum calculable amount of funds equaling certain of their obligations to their customers, as well as a certain minimum amount of their own capital – known as their targeted residual interest – in specially designated customer segregated accounts. Click here for an overview of these requirements.)

When Mr. Russo observed this error the next morning, May 11, 2014, he instructed the same staff accountant to have Cunningham’s bank transfer the necessary funds from the house to a customer segregated account “as of” the prior business day. The bank made this transfer. However, on the same day, Mr. Russo did not cause the firm to file notice of its regulatory breach with the CFTC or report this matter to the firm’s chief compliance officer.

On May 11, the Chicago Mercantile Exchange observed this error, apparently through a comparison of the firm’s formal report of customer segregated funds filed with it, and with bank statements of the firm’s customer segregated accounts filed directly with it by depositories holding its customers’ funds.

Cunningham’s CCO was not aware of this matter when contacted by the CME on March 11, 2014. The following day, Cunningham notified the CFTC of its March 10 deficiencies. The CFTC claimed this notice filing was delinquent.

In addition, the CFTC alleged that, from November 27, 2013, to May 14, 2014, and from July 3 to 15, 2014, Cunningham failed to include certain positions in its required reports to the CFTC of positions of its large traders. During the earlier period, the firm excluded silver contract positions, and during the later period failed to include soybean option positions. According to the CFTC, the firm said the reporting problem was attributable to the failure of an outside software vendor to properly set up the relevant contracts for reporting. (Under applicable CFTC rules, FCMs are obligated to daily report to the CFTC positions in excess of certain levels of its large traders – known as reportable positions (click here for an overview of the CFTC’s large trader reporting program)).

The respondents neither admitted nor denied any of the CFTC’s findings or conclusions in agreeing to the settlement.

Compliance Weeds: CFTC Regulation 1.12 requires that FCMs provide notice to the CFTC on a heightened schedule from “immediately” to within two business days, depending on the specific subsection, of certain specified violations of CFTC rules. Immediate notice to the CFTC is required, for example, when an FCM’s adjusted net capital falls below minimum required amounts or when the amount of funds it carries in its customer segregated accounts is less than required by the applicable regulation. (Click here to access CFTC Regulation 1.12; click here to access a convenient chart prepared by the National Futures Association enumerating CFTC’s required notice and other filings.) Any notice required to be filed with the CFTC by an FCM must also be filed with the firm’s designated self-regulatory organization, as well as with the Securities and Exchange Commission if the FCM is also registered with the SEC as a broker-dealer. CFTC Regulation 1.12 also includes some notice filing obligations for introducing brokers and self-regulatory organizations. Every notice filled under CFTC Regulation 1.12 must include a discussion of how the reporting event originated and what steps have been, or are being, taken to fix the reporting event. When regulated entities discover potentially reportable events they should be conscious of the time frames required for reporting and not unnecessarily delay a filing while researching the potential issue. On the other hand, care should be taken to avoid filing information that has to be repeatedly amended.

My View: The CFTC sends a clear message in bringing this enforcement action against both the FCM and its controller that it will name individuals who it believes are responsible for a firm’s wrongdoing, even if seemingly done in good faith. Here, the FCM’s controller saw that a required transfer of funds had not been made when required but fixed the mistake by instructing the firm’s bank to transfer the funds “as of” the time the correct transfer should have been made. However, in the CFTC’s view, a retroactive fix, while a fix, still gave rise to a reportable event. Indeed, in this enforcement action, the firm did not sue respondents because Cunningham breached its customer segregated funds’ requirements, but solely for not immediately reporting the customer segregated funds and residual interest breaches when they were discovered. Fortunately, the CFTC demonstrated wise discretion in not also naming Cunningham’s CCO in this matter.

Briefly:

Culture and Ethics: Apparently, on June 16, 2014, in the middle of Mr. Ayhan’s ongoing alleged fraud, Mr. Ayhan requested a subordinate to falsely mark the book of his trading desk when he was out of the office one day while on leave. Although the subordinate questioned Mr. Ayhan’s proposed marks, terming them “absurd,” he followed his boss’s instructions when Mr. Ayhan said he would correct them the following day and disclose the “true” profit and loss to management. The next day, Mr. Ayhan returned to work and advised his subordinate that he would not correct the marks or disclose the true P&L to management. Although DFSA's decision notice does not disclose whether the subordinate at that time informed his employer bank’s management of Mr. Ayhan’s behavior, it is alleged that Mr. Ayhan’s purportedly wrongful practices continued for at least one more month. All employees within a company must continuously be reminded of their obligation to report improper, let alone illegal, conduct to designated persons. Reporting wrongful conduct internally (without fear of retaliation) must be imbedded in the culture of each legal entity.

My View: From the outset, I have had difficulty understanding the meaning of “spoofing” as defined under the Commodity Exchange Act. Although the law expressly defines spoofing in a parenthetical phrase as “bidding or offering with the intent to cancel the bid or offer before execution,” defining an offense – if the definition is wrong or universally regarded as unclear – does not provide the type of fair notice that is necessary to make a law constitutionally valid. When the Financial Industry Regulatory Authority recently issued report cards to member firms to help them detect potential spoofing and layering activity, FINRA defined spoofing as “entering orders to entice other participants to join on the same side of the market at a price at which they would not ordinarily trade, and then trading against the other market participants’ orders” – a very different definition than that in the CEA. (Click here for background on FINRA’s new spoofing report cards in the article, “FINRA Hands Out Report Cards on Potential Spoofing and Layering” in the May 1, 2016 edition of Bridging the Week.) Although the CME Group enacted a provision prohibiting spoofing that parallels the similar CEA provision, it issued an advisory that made clear that the concept of spoofing is muddy at best. For example, a stop order is often placed with the desire that it will never be executed because execution would mean that a position is moving in an adverse direction. However, CME Group distinguished between “intent” and “hope” when saying that stop orders did not violate its prohibition against spoofing in a way that leaves a reasonable person rightfully scratching his or her head:

Market 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. Such an order is not prohibited [by the applicable CME Group] Rule.

Indeed, if there was any doubt regarding the vagueness of what is prohibited, the Intercontinental Exchange, through three of its exchanges in Europe, Canada and the United States, uses three similar but subtly differently drafted rules to prohibit disruptive trading. (Click here for details of ICE’s different rules in the article, “ICE Futures Europe to Adopt Another Variation of Disruptive Trading Practices Rule” in the January 11, 2015 edition of Bridging the Week.) Even at the same time that Michael Coscia settled with the Commodity Futures Trading Commission in 2013 for prohibited “spoofing,” he settled with the Financial Conduct Authority in the United Kingdom for the identical conduct – but there it was termed “layering” (click here to access a copy of FCA’s Final Notice regarding Mr. Coscia). The CEA provision prohibiting spoofing was badly drafted because it prohibits a named activity that has different meanings to different people rather than banning the purportedly bad conduct itself. There is no one commonly accepted definition of what constitutes spoofing, despite the parenthetical clause in the applicable law. Thus, there is no fair notice of what is prohibited.

And more briefly:

And finally:

For more information, see:

Alleged Spoofer in CFTC Enforcement Action Claims Relevant Statute and Regulation Unconstitutionally Vague:
/ckfinder/userfiles/files/Oystacher%20Motion%20May%202016.pdf

Broker-Dealer Sanctioned by FINRA for Alleged Failure to Supervise Use of Flash Research Emails That Might Convey Nonpublic Information:
http://www.finra.org/sites/default/files/Stephens_AWC_051116.pdf

CFTC Proposes to Confirm Electricity Transmission Organizations' Exemption From Most Provisions of Commodity Exchange Act But Will Permit Private Lawsuits:
http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/federalregister051016.pdf

Controller of FCM Named in CFTC Complaint for Failure to Timely Notify Commission of Segregation Breach:
http://www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfcunninghamorder050916.pdf

Dubai-Based Trader Barred by DFSA for Hiding Trading Losses of US $11 Million by Mismarking Positions:
http://dfsa.ae/Documents/Regulatory-Actions-2016/001_NA_Decision_Notice_300316.pdf

Incoming FCA Head Identifies “Hubris Risk” As Among the Risks Banks Can Mitigate Only Through a Strong Culture:
http://www.bankofengland.co.uk/publications/Documents/speeches/2016/speech901.pdf

Inspection Unit Criticizes CFTC’s Renting of Unused Office Space:
http://www.cftc.gov/idc/groups/public/@aboutcftc/documents/file/oig_rdc042516.pdf

IOSCO Cautions on Regulatory Gaps Storage of Infrastructures for Exchange-Traded Physically Delivered Commodity Derivatives:
http://www.iosco.org/library/pubdocs/pdf/IOSCOPD530.pdf

ISDA and Other Industry Organizations Adopt International Cybersecurity Core Principles:
http://www.gfma.org/correspondence/item.aspx?id=807

No Change to Deadline for FCMs to Top-Up Customer Segregated Accounts Recommended by CFTC Staff:
http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/residualinterestreport050616.pdf

Ontario and Quebec Publish Final Rules to Enhance OTC Swaps Trading Transparency:

Ontario:
http://www.osc.gov.on.ca/en/SecuritiesLaw_rule_20160512_91-507_derivatives-data-reporting.htm
Quebec:
https://www.lautorite.qc.ca/en/pending-ministerial-derivatives-pro.html

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of May 14, 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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ABOUT GARY DEWAAL

Gary DeWaal

Gary DeWaal is currently Special Counsel with Katten Muchin Rosenman LLP in its New York office focusing on financial services regulatory matters. He provides advisory services and assists with investigations and litigation.


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