Commentaries

Bridging the Week by Gary DeWaal: June 13 to 17 and 20, 2016 (Who’s a Customer?; Front-Running; Spoofing; Block Trades; Red Flags)

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Published Date: June 19, 2016

Last week, the Securities and Exchange Commission overturned a decision of the Chicago Board Options Exchange in a disciplinary matter that had fined a broker-dealer and two principals US $1 million for not applying customer identification and margin requirements to traders of two omnibus customers. The SEC said CBOE misunderstood who the broker-dealer’s customers were. Separately, a trader was sanctioned over US $3 million by the New York Mercantile Exchange for trading on his employer’s confidential information to the detriment of his employer; while the Commodity Futures Trading Commission submitted papers in an enforcement action in a Chicago federal court arguing that the definition of spoofing under US futures law is clear. But is it? As a result, the following matters are covered in this week’s edition of Bridging the Week:

Video Version:

Article Version:

SEC Overturns CBOE Determination That Individual Traders of Two Omnibus Accounts Were Customers Requiring Application of Customer Identification Rule

The Securities and Exchange Commission set aside a determination by the Chicago Board Options Exchange, Inc. that Electronic Transaction Clearing, Inc., and two of its principals, Kevin Murphy and Harvey Cloyd, Jr., failed to apply its customer identification program to individuals trading on behalf of two omnibus accounts; failed to apply margin rules to the same traders; and failed to implement adequate surveillance tools for identifying suspicious activities of its customers.

CBOE previously filed charges in 2011 against the firm, the two principals, and the firm’s chief compliance officer and anti-money laundering compliance officer claiming that, between December 2009 and July 2010, the firm failed to comply with the CIP rule and margin requirements in connection with the multiple individual traders. (The CIP rule references a requirement under law and of the Financial Crimes Enforcement Network of the US Department of Treasury that broker-dealers, as well as certain other financial institutions, must obtain, verify and record certain information that identifies each person who opens an account; click here for more information related to requirements of broker-dealers.)

The BCC also found that the firm failed to have adequate surveillance tools in 2010 because for a portion of the year, it temporarily de-activated its electronic monitoring system for potential wash sales and other possible manipulative activity. The BCC identified other violations too (i.e., the failure to conduct an independent audit of its AML program in 2009 and the failure to timely close out one customer short sale in 2010) and imposed a US $1 million fine against ETC and the two principals, as well as other sanctions.

The firm and the two principals appealed the BCC’s decision to CBOE’s Board of Directors; the Board upheld the BCC’s decision. The applicants then appealed to the SEC.

In ruling against CBOE, the SEC said the CIP rule only required ETC “to verify the identity of the named account holder.” Because ETC’s named customers were the two omnibus brokers, it was only required to apply its CIP requirements to them. For this reason too, only the omnibus brokers, not their traders, were subject to CBOE’s margin rules.

Finally, the SEC noted that ETC temporarily deactivated its surveillance system for bona fide reasons – to make the monitoring tool web-based, as it was requiring “extensive computer resources to run,” and not operating efficiently. During the time it deactivated its automated monitoring system, ETC employed other measures to help prevent wash and manipulative trading. Moreover, once it reactivated its automated surveillance system, ETC reviewed all trades that occurred while the system was down, said the SEC. As a result, concluded the SEC, ETC’s wash sale surveillance was not “unreasonable” during the relevant time period.

The SEC remanded the entire action against the firm and the two principals back to CBOE for reconsideration as CBOE’s fine and sanctions were based on findings related to all its initial charges, including the ones the SEC set aside in its decision.

Compliance Weeds: The Financial Crimes Enforcement Network recently finalized rules requiring banks, broker-dealers, future commission merchants, introducing brokers and mutual funds (collectively, “covered firms”) to identify the beneficial owners of their legal entity customers. Such entities are currently required to know the identity of each of their legal entity customers under their CIP requirements, but not necessarily their beneficial owners. FinCEN also adopted rules making explicit the obligation of covered firms to understand the nature and purpose of their customer relationships in order to develop customer risk profiles; conduct ongoing monitoring for reporting suspicious transactions; and, on a risk basis, maintain and update customer information. Covered firms must comply with FinCEN’s new rules beginning May 11, 2018. (Click here for details of these new rules in the article, “FinCEN Finalizes Rules Requiring Banks, Broker-Dealers, FCMs, Mutual Funds and IBs to Help Verify Beneficial Owners of Certain Accounts” in the May 8, 2016 edition of Bridging the Week.)

Trader Sanctioned Over US $3 Million by CME Group for Trading on Confidential Employer Information; Both He and Wife Barred From Exchange Trading

A panel of the Business Conduct Committee of the New York Mercantile Exchange found that, from April 18, 2012, through December 10, 2012, Jon Ruggles, a nonmember and former trader for Delta Airlines, traded two accounts of his wife, Ivonne Ruggles, relying on confidential information of his employer in a manner that disadvantaged it.

According to the BCC, on 82 instances during this time period, Mr. Ruggles either initiated a new position opposite his employer’s account, offset an existing position opposite his employer’s account, or front-ran orders ultimately placed for his employer’s account. The BCC found that Mr. Ruggles “was not authorized at any time to execute trades between the employer’s account and the commodity trading accounts of his wife.”

The BCC concluded that, during the relevant period, Mr. Ruggles accumulated profits in excess of US $3.3 million as a result of his unauthorized trading.

As a penalty, the BCC imposed a fine of US $500,000 against Mr. Ruggles, ordered disgorgement in excess of $2.8 million, and imposed a permanent CME Group all-products trading prohibition. The BCC did not order disgorgement of the entire amount of his alleged illicit profits because it noted that CME Group exchanges did not have the requisite authority to impose such a sanction on a nonmember until August 20, 2012.

Ms. Ruggles failed to appear for an interview requested by NYMEX staff in connection with the trading of her husband. In response, the BCC imposed a permanent CME Group all-products trading ban on Ms. Ruggles too. (Click here to access an article in the June 16, 2014 edition of Fortune describing trading and other activities by Mr. Ruggles.)

Totally Irrelevant (But Is it?): I hate footnotes in legal articles. My view has always been that if the text is important, include it in the body of the article; if it’s not important, don’t include it at all. However, much legal writing uses footnotes interchangeably both as depositories of very important information and very irrelevant information, as well as information that simply is not well explained. To me this is very bad practice and mandates a careful perusal of all footnotes (no matter how tiny the font) to all legal articles to see if anything important is buried there. (Click here to access a wonderful parody of lawyers’ writing style, include their use of footnotes, in the article, “The Common Law Origins of the Infield Fly Rule” in a 1975 edition of the University of Pennsylvania Law Review.) Footnotes were not used in the NYMEX disciplinary notice related to Mr. Ruggles’s alleged wrongdoing, but buried in the “Penalty” section of the notice was an ominous reference to another potentially pending legal action again Mr. Ruggles  this one by the Commodity Futures Trading Commission. According to the BCC, “[t]he Panel found that if Ruggles reached a settlement with the CFTC that included disgorgement of profits or should he be required to disgorge profits pursuant to a Court order, a dollar-for-dollar credit for the amount that Ruggles pays to the CFTC in disgorgement shall be credited against the disgorgement amount ordered by the Panel.” Foreboding? Stay tuned!

DOJ and SEC Charge Former FDA Official With Obtaining Confidential Information to Fuel Insider Trading by Hedge Fund Managers

The US Department of Justice and the Securities and Exchange Commission filed criminal and civil charges, respectively, against a former government official who obtained confidential information from his former agency, and then provided it to a hedge fund manager for trading.

According to the SEC, Sanjay Valvani  a hedge fund manager, realized US $32 million in illicit profits after receiving information about the likely approval by the Federal Drug Administration of a new generic drug and trading upon it. He received this information, charged the SEC in a civil complaint filed in federal court in New York, from Gordon Johnston, a former senior FDA officer, whom he had hired as a consultant. Mr. Johnston obtained this information through a former colleague at the FDA, said the SEC. In response, the SEC alleged that, in addition to trading on the information himself, Mr. Valvani shared this information with another former hedge fund manager, Stefan Lumiere, who likewise traded on the insider tips.

Mr. Johnston has pleaded guilty and admitted to his conduct in the DOJ criminal action.

The DOJ and SEC also filed criminal and civil charges against Mr. Lumiere and Christopher Plaford, another former hedge fund manager, for overstating the value of credit securities in funds they managed.

These individuals accomplished this, charged the DOJ and SEC, by instructing certain “friendly” broker-dealers of the specific prices they wanted for illiquid securities held by the funds and having the brokers send the prices back to them to be used as benchmarks for the funds’ valuations. The DOJ and SEC also charged that, on occasion, Mr. Plaford would purchase securities at higher than market prices (i.e., so-called “painting the tape”) to inflate the value of the securities and the value of the funds’ portfolio that included the securities.

Mr. Plaford has pleaded guilty to his criminal charges and admitted his role in the process.

In another matter, Rohit Bansal, the former Goldman Sachs & Co. and Federal Reserve Bank of New York employee, who illicitly obtained confidential information from the Fed while employed by GSCO for use by GSCO, agreed with the Financial Industry Regulatory Authority to be permanently barred from associating with any FINRA member. Mr. Bansal previously pleaded guilty to criminal charges related to this matter. (Click here for details in the article, “Alleged Criminal Conduct Snares Multiple Ex-Financial Services and Regulator Defendants in New York” in the November 8, 2015 edition of Bridging the Week.)

My View: It is precisely because of incidents like those involving Mr. Johnston and Mr. Bansal that industry representatives are so concerned about the proposal of the Commodity Futures Trading Commission in Regulation Automated Trading to require the proprietary source code of algorithmic traders to be made readily available to its staff and employees of the Department of Justice. Although regulators strive hard to prevent improprieties by their employees, they cannot prevent such incidents. Algorithmic traders potentially covered by Reg AT are very concerned that source code obtained by government regulators through a too low standard could make its way to competitors. Inadvertent leaks because of cybersecurity breaches are also a worry. This is why any provision adopted by the CFTC related to its or the DOJ’s ability to access source code must include sufficient protections against inadvertent leaks and disclosures. (Click here for an overview of industry comments to Regulation AT in the article, “Industry Comments to Regulation AT Argue CFTC Proposed Rules Too Prescriptive; Registration and Source Code Requirements Particularly Objectionable” in the March 20, 2016 edition of Bridging the Week.)

Briefly:

My View: Although the relevant provision of law defines spoofing very precisely 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, for example, it 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.” FINRA’s definition does not require intent to cancel the bid or offer before execution; however it requires order placement on both sides of a market. (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 CFTC may believe that everyone knows what spoofing is, the relevant statute is badly drafted and the parenthetical language that supposedly defines spoofing embraces both legitimate and potentially problematic conduct. Indeed, the CFTC acknowledged in its court papers last week that this was the industry’s position “under a literal reading of the spoofing provision.” However, argued the CFTC in its papers, “[t]he Complaint [in this matter] had nothing to do with these industry concerns.” It seems disingenuous for the CFTC to concede the controversy but claim it is irrelevant. If a law is too sweeping in scope, though it may be worded precisely, it does not provide adequate notice of what is allowed or prohibited. 

And more briefly:

For more information, see:

Canadian Regulator AMF to Review Financial Innovations in the Financial Sector:
https://www.lautorite.qc.ca/en/press-releases-2016-pro.html_2016_technological-innovation-in-the-financial-sector-amf-creates-fintech-working-group13-06-2016-00-0.html

CFTC Seeks Public Comment on IFUS Proposed Block Trade Guidance Change:
http://www.cftc.gov/idc/groups/public/@otherif/documents/ifdocs/icefuturesstay061416.pdf

CFTC Tells Court That Meaning of Spoofing Is Clear in Case Against Trader:
/ckfinder/userfiles/files/Oystacher%20%20CFTC.pdf

Cleared Swaps Recordkeeping and Reporting Requirements Amended by CFTC:
http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/federalregister061416.pdf

CME Group Amends Approval Process for Subordinated Loans to Clearing Members:
http://www.cmegroup.com/notices/clearing/2016/06/frb--16-02.html#pageNumber=1

CME Group Authorized to Provide Clearing Services in the EU:
http://www.cmegroup.com/notices/clearing/2016/06/Chadv16-231.pdf

DOJ and SEC Charge Former FDA Official With Obtaining Confidential Information to Fuel Insider Trading by Hedge Fund Managers:

DOJ:
https://www.justice.gov/usao-sdny/file/867221/download
https://www.justice.gov/usao-sdny/file/867226/download
https://www.justice.gov/usao-sdny/file/867231/download
https://www.justice.gov/usao-sdny/file/867236/download
SEC:
https://www.sec.gov/litigation/complaints/2016/comp-pr2016-119-valvani-johnston.pdf
https://www.sec.gov/litigation/complaints/2016/comp-pr2016-119-plaford.pdf
https://www.sec.gov/litigation/complaints/2016/comp-pr2016-119-lumiere.pdf

ICE Futures Europe Amends Guidance on Block and Asset Allocation Trades:
https://www.theice.com/publicdocs/futures/ICE_Futures_Block_Trade_Policy.pdf

IEX Approved as a National Securities Exchange:
https://www.sec.gov/litigation/opinions/2016/34-78093.pdf

IFUS Sanctions FCM for LTR Violations and IB for Block-Trading Handling Breakdowns:

Bosworth:
/ckfinder/userfiles/files/IFUS%20Settlement%20of%20Charges%20Against%20Bosworth%20Brokers%20LLC.pdf
Wedbush:
/ckfinder/userfiles/files/IFUS%20Settlement%20of%20Charges%20Against%20Wedbush%20Securities%2c%20Inc_(1).pdf

MiFID II and MiFIR Formally Delayed One Year:
http://www.consilium.europa.eu/en/press/press-releases/2016/06/17-markets-in-financial-instruments/

Private Fund Administrator Settles Charges With SEC for Not Acting on Red Flags of Possible Fraud:
https://www.sec.gov/litigation/admin/2016/ia-4428.pdf
https://www.sec.gov/litigation/admin/2016/ia-4429.pdf

SEC Inspector General Criticizes Agency’s Sensitive Information Security:
https://www.sec.gov/oig/reportspubs/Audit-of-the-SECs-Compliance-with-the-Federal-Information-Security-Modernization-Act-for-Fiscal-Year-2015.pdf

SEC Overturns CBOE Determination That Individual Traders of Two Omnibus Accounts Were Customers Requiring Application of Customer Identification Rule:
https://www.sec.gov/litigation/opinions/2016/34-78093.pdf

Trader Sanctioned Over US $3 Million by CME Group for Trading on Confidential Employer Information; Both He and Wife Barred From Exchange Trading:
http://www.cmegroup.com/notices/disciplinary/2016/06/NYMEX-12-9153-BC-1-JON-RUGGLES.html#pageNumber=1
http://www.cmegroup.com/notices/disciplinary/2016/06/NYMEX-12-9153-BC-2-IVONNE-RUGGLES.html

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of June 18, 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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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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