Bridging the Week by Gary DeWaal

ICE Futures U.S. has followed the Chicago Mercantile Exchange in amending its rule and issuing new Frequently Asked Questions regarding exchange of futures for related position transactions. Transitory EFRPs will now be prohibited but so-called “offsetting” EFRPs involving foreign currency will be allowed as at the CME. Is this Lord Voldemort hovering over the futures industry again (i.e., the “transactions that must not be named”)? Some exchange disciplinary actions last week involving claims of wash trades against non-members also warrant note, as does a Eurex warning about the eligibility of US persons for certain of its futures contracts that require the making or taking of delivery of over-the-counter interest rate swaps.

As a result, the following matters are covered in this week’s Bridging the Week:

• ICE Futures U.S. Issues Amendments to Rule and New Frequently Asked Questions Related to EFRPs;
• Ex-Citadel Employee Pleads Guilty to Obstructing Probe Into Theft of HFT Software Days After Another Ex-Employee Pleads Guilty to Taking Proprietary Algorithms (includes Valuable Lessons Learned);
• CME Group Publicizes Various Disciplinary Actions Against Nonmembers for Alleged Wash Trades Violations;
• ICE Futures U.S. Sanctions Energy Fund for Alleged Position Limit Violations;
• IIROC Grants 60-Day Extension to Update Client Agreements for Third-Party Electronic Access to Marketplaces (includes Helpful to Getting the Business Done);
• Eurex Warns Euro-Swap Futures Contracts Are Prohibited for US Persons (includes Compliance Weeds);
• SEC Sues Kansas for Misleading Pension Liability Disclosures in Bond Offering Documents; and more.

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ICE Futures U.S. Issues Amendments to Rule and New Frequently Asked Questions Related to EFRPs

Last week, ICE Futures U.S. adopted amendments to its rule, and issued a new Frequently Asked Questions advisory regarding, exchange of futures for related positions.

In general, the amendments expressly require that, for each EFRP, there be a bona fide transfer of ownership of the relevant cash commodity between the parties, or a “legally binding contract between the parties consistent with relevant market conventions for the particular related product transaction.”

The amendments also expressly prohibit so-called “transitory EFRPs” by making it clear that the execution of one EFRP cannot be made contingent on the execution of another EFRP or related position transaction involving the same parties where the two transactions result in the offset of the related position without the parties incurring market risk. Notwithstanding, according to the exchange’s new FAQs, immediately offsetting exchange of futures for physical positions involving foreign currency futures are not prohibited as transitory EFRPs (an EFP is a type of EFRP). This is because, say the FAQs,

…in such transactions, the offsetting physical transaction cannot be contingent on the execution of the EFP. For example, if the futures leg of an immediately offsetting EFP in foreign currency is not accepted for clearing, the futures transaction and corresponding cash/[over the counter] component of the EFP would be void and the counterparties would be left with the stand-alone physical currency transaction that was not a component of the EFP.

In an EFRP transaction one party goes long (or short) a futures position and takes the opposite side in the related position. In a transitory EFRP, a party purchases (or sells) a futures contract and first takes the opposite action – a sale (or purchase) – in connection with the related position, and then immediately or nearly immediately offsets the related position – all against the same counterparty with no market risk.

Also exempted from the ban against transitory EFRPs at ICE Futures under its amended rule are certain financing transactions involving storable agricultural, energy or metal commodities that are typically structured as contingent EFPs or so-called "against actuals" transactions.

Earlier this year, the Chicago Mercantile Exchange likewise amended its EFRP rule in a similar way. This change went into effect on August 4.  (For details of the CME rule amendment and its new related FAQ, click here to see the article “Lord Voldemort Hovers Over the Futures Industry: CME Prohibits All Transitory Exchange of Futures for Related Positions by Name” in the April 14, 2014 edition of what is now called Between Bridges.) 

ICE Futures’ amended rule and FAQs are expected to take effect on September 5, except for certain documentation requirements applicable to commodity trading advisors and other account controllers, which are expected to become effective on October 1.

For information on other nuanced changes to ICE’s EFRP rule click here to access “ICE Futures U.S. Issues Amendments to EFRP Rule and FAQs” in the August 15, 2014 edition of Corporate & Financial Weekly Digest by Katten Muchin Rosenman LLP. 

Ex-Citadel Employee Pleads Guilty to Obstructing Probe Into Theft of HFT Software Days After Another Ex-Employee Pleads Guilty to Taking Proprietary Algorithms

Two weeks ago, ex-Citadel LLC employee Yihao Pu, pled guilty to unlawfully taking proprietary trading strategy algorithms from two companies, including Citadel. Last week Sahil Uppal pled guilty to obstructing justice by assisting his former colleague’s illicit conduct.

According to Mr. Pu’s plea agreement, prior to joining Citadel as an employee in May 2010, Mr. Pu worked for an unnamed high-frequency trading firm in Red Bank, New Jersey, where he helped test and analyze trading strategies. In March 2010, on the day before he resigned from the unnamed firm, Mr. Pu allegedly downloaded “thousands of files,” including the firm’s HFT source code, to his personal computer. He was not authorized to do this.

Subsequently, Mr. Pu began work at Citadel in Chicago, Illinois to help develop and improve his new employer’s HFT strategies. During August 2011, Mr. Pu allegedly copied certain of Citadel’s proprietary software and other information to his own computer – which he again was not authorized to do. After he was confronted regarding his actions by Citadel representatives on August 26, 2011, Mr. Pu – with the alleged assistance of Mr. Uppal and another unnamed individual – endeavored to hide his personal computer equipment that contained the software he had illicitly obtained from Citadel and his prior employer. Mr. Pu later erased some of the data from his computer equipment and had some of the computer equipment tossed into a nearby sanitary canal.

Mr. Uppal had joined Citadel in September 2010, also to research and develop HFT strategies.

Mr. Pu faces a possible sentence of up to 20 years imprisonment and a maximum fine of US $500,000, while Mr. Uppal faces up to the same imprisonment time and a maximum fine of US $250,000. Sentencing is scheduled in a US federal court in Chicago on November 7.

Valuable Lessons Learned: Not only should firms maintain systems and processes to ensure that all confidential information – including proprietary information (whether on computer systems or otherwise) – is protected, but they should also routinely monitor for external and internal threats to their computer systems, as well as other locations where confidential information may be retained. Moreover, firms should ensure that their employment manuals include a robust section on the use and handling of confidential information, and that employees are frequently reminded of this section. All employees should be required to acknowledge receipt of a company’s employment manual upon hiring and periodically afterwards and, along with relevant agents (e.g. on-site consultants), be required to execute formal agreements pledging to maintain confidential information appropriately and not to use it other than for authorized purposes.

CME Group Publicizes Various Disciplinary Actions against Nonmembers for Alleged Wash Trade Violations

The CME Group publicized three disciplinary actions against non-members for violations of the New York Mercantile Exchange’s prohibition against wash trades.

In one action, Barclays Bank PLC agreed to pay US $90,000 as a sanction in connection with alleged wash block trades that were executed between accounts of the bank and Barclays Capital Energy Inc., a subsidiary, on multiple dates between March 2010 and December 2011. NYMEX’s Business Conduct Committee concluded these trades were undertaken to transfer positions from the bank’s account to the subsidiary’s account.  The BCC also found that the bank failed to supervise adequately certain internal personnel “to ensure that they provided accurate guidance” with respect to these trades. Barclays Bank did not admit or deny the relevant rule violations in connection with its settlement.

In an unrelated action, Suncor Energy Marketing Inc. and Steven McMane were also charged with violating NYMEX’s prohibition against wash trades for certain transactions from August to November 2012 in three accounts with the same beneficial that were made in order to offset positions in an expiring crude oil futures contract. In connection with these transactions, Suncor agreed to pay a fine of US $40,000 without admitting or denying any rule violations, and Mr. McMane agreed to pay a fine of US $15,000 and be suspended from trading CME Group products for five business days.

NYMEX asserted jurisdiction over Barclays Bank as it is an affiliate of an exchange member, and over Suncor and Mr. McMane under its rule which states: 

[a]ny Person initiating or executing a transaction on or subject to the Rules of the Exchange directly or through an intermediary, and any Person for whose benefit such a transaction has been initiated or executed, expressly consents to the jurisdiction of the Exchange and agrees to be bound by and comply with the Rules of the Exchange in relation to such transactions...

And briefly:

• ICE Futures U.S. Sanctions Energy Fund for Alleged Position Limit Violations: ICE Futures U.S. agreed to settle with Skylar Capital Energy Global Master Fund, LP for two alleged violations of its speculative position limit rules. In one instance the fund was charged with violating the exchange’s spot month position limit in the June 2013 Henry Swing futures contract. In the other instance, it was charged with violating a conditional limit granted by the exchange in connection with the June 2013 Henry LD1 Fixed Price futures contract. To resolve this matter, the fund agreed to pay a penalty of US $199,960, which included disgorgement of US $148,960. The fund did not admit or deny any alleged rule violation.
   
• IIROC Grants 60-Day Extension to Update Client Agreements for Third-Party Electronic Access to Marketplaces: The Investment Industry Regulatory Organization of Canada has granted a potential 60-day extension to marketplace participants to include certain mandatory terms in their direct electronic access routing agreements that were in effect as of March 1, 2014. These amendments were to have been made by September 1 (all new agreements must contain the relevant terms). To gain an extension, a participant must file a formal request containing certain required information.

Helpful to Getting the Business Done: IIROC’s new rules require certain mandatory provisions in direct access routing agreements. Many of these provisions, including certain client representations and warranties (e.g. regarding financial capability and competence, authorized traders, monitoring capability); client commitment to comply with applicable law; client agreement to cooperate with regulatory inquiries; and participant rights regarding orders (e.g., to reject or cancel), are worth considering for direct access agreements that are not subject to IIROC’s oversight.

• Eurex Warns Euro-Swap Futures Contracts Are Prohibited for US Persons: Eurex has issued a circular reminding its members that Eurex Clearing AG is prohibited from clearing Euro-swap futures contracts for US persons traded on Eurex Deutschland and Eurex Zurich. This is because such contracts require the making or taking delivery of an OTC interest rate swap that clears through Eurex Clearing. As Eurex Clearing is not currently a registered derivatives clearing organization with the US Commodity Futures Trading Commission, it is prohibited from dealing with US persons in connection with cleared OTC swaps at this time. Eurex is requiring its members to make certain representations to it in order to ensure this prohibition is honored.

Compliance Weeds: Traditionally, US persons can trade all but certain non-US futures and related options. For example, US persons may not trade futures based on broad-based non-US securities indices unless approved by the CFTC, or on a sovereign debt instrument unless the Securities and Exchange Commission has designated the instrument as a so-called “exempted security.” Eurex’s circular is a reminder that US persons may now also be precluded from trading in certain foreign futures contracts where delivery or taking delivery of an OTC contract is mandatory at contract termination, unless such OTC contract clears through a CFTC-designated derivatives clearing organization. (For details regarding CFTC-approved foreign futures and related options click here to see the “Foreign Listed Stock Index Futures and Options Approvals” by Katten Much Rosenman LLP, current as of April 16, 2014.) 

• SEC Sues Kansas for Misleading Pension Liability Disclosures in Bond Offering Documents: The SEC sued the State of Kansas for misleading investors through its bond offering documents by not disclosing that the state’s pension system was materially underfunded and created substantial repayment risk for investors. To settle this matter, the state agreed to cease and desist from further violations. Specifically, the SEC claimed that from August 2009 through July 2010, the Kansas Development Finance Authority sold US $273 million worth of bonds on behalf of the state without making adequate disclosure. At the time, says the SEC, “according to one study, [the Kansas Public Employees Retirement System] was the second-most underfunded statewide pension system in the nation.” The SEC previously sanctioned the states of Illinois and New Jersey for similar non-disclosure regarding their underfunded pension plans.
   
• SEC and Linkbrokers Settle Over Charges That Broker-Dealer Misled Customers Regarding Markups and Markdowns and Stole a Portion of Their Trades: Linkbrokers Derivatives LLC, a former NY-based interdealer broker, agreed to pay the SEC US $14 million as disgorgement to settle charges that, from at least 2005 to February 2009, it took more than US $18 million from customers through hidden markups and markdowns to more than 36,000 trades. The SEC also alleged that the firm made additional money by filling customer orders at their limit prices and then selling the resulting positions back to the market at a profit if the market moved favorably. Later, Linkbrokers would report to the customers it was unable to fill their limit orders at their requested prices. The SEC previously charged four former members of Linkbrokers’ cash equities desk in relation to this matter and settled with three of them for a disgorgement payment of US $4 million. Three of these brokers have also pled guilty to criminal charges related to their conduct. Linkbrokers stopped acting as a broker-dealer in April 2013 and has now withdrawn its SEC registration.

For more information, see:

CME Group Disciplinary Actions:

Barclays Bank:
https://www.nfa.futures.org/BasicNet/Case.aspx?entityid=0209452&case=12-9033-BC+BARCLAYS+BANK+PLC&contrib=NYME
Steven McMane:
https://www.nfa.futures.org/BasicNet/Case.aspx?entityid=0479625&case=13-9498-BC+STEVEN+MCMANE&contrib=NYME
Suncor Energy Marketing Inc:
https://www.nfa.futures.org/BasicNet/Case.aspx?entityid=0479624&case=13-9498-BC+SUNCOR+ENERGY+MKTNG+INC.&contrib=NYME

Eurex Warns Euro-Swap Futures Is Prohibited for US Persons:
https://www.eurexchange.com/blob/exchange-en/4060-1040362/1040364/2/data/er14183e.pdf

Ex-Citadel Employee Pleads Guilty to Obstructing Probe Into Theft of HFT Software Days After Another Ex-Employee Pleads Guilty to Taking Proprietary Algorithms
/ckfinder/userfiles/files/USA%20v%20Sahil%20Uppal%20(Plea%20Agreement)(1).pdf
/ckfinder/userfiles/files/USA%20v_%20Yihao%20Pu%20(Plea%20Agreement)(1).pdf

ICE Futures U.S. Issues Amendments to Rule and New Frequently Asked Questions Related to EFRPs:
https://www.theice.com/publicdocs/regulatory_filings/14-72_Amendment_to_Rule_4.06_and_EFRP_FAQ.docx.pdf

ICE Futures U.S. Sanctions Energy Fund for Alleged Position Limit Violations:
/ckfinder/userfiles/files/Skylar%20Capital%20Energy%20Global%20MF.pdf

IIROC Grants 60-Day Extension to Update Client Agreements for Third-Party Electronic Access to Marketplaces:
http://www.iiroc.ca/Documents/2014/fb908eae-2ca0-4afd-9208-76b6177bff9e_en.pdf

See also:
IIROC Notice Regarding Third-Party Electronic Access (July 4, 2013):
http://www.iiroc.ca/Documents/2013/68195f8b-148c-4e1f-89f4-8658f0f40ba8_en.pdf
IIROC Rule 7.13 (Direct Electronic Access and Routing Agreements):
http://www.iiroc.ca/industry/rulebook/Documents/UMIR0713_en.pdf

SEC and Linkbrokers Settle Over Charges That Broker-Dealer Misled Customers Regarding Markups and Markdowns and Stole a Portion of Their Trades:
http://www.sec.gov/litigation/admin/2014/34-72846.pdf

See also:
SEC Complaint Against Four Defendants:
http://www.sec.gov/litigation/complaints/2012/comp-pr2012-207.pdf
Information Regarding the Criminal Proceedings Against Three Defendants:
http://www.justice.gov/usao/nys/pressreleases/November13/ChouchaneBenjaminSentencingPR.php?print=1
http://www.justice.gov/usao/nys/pressreleases/January14/MarekLeszcznskiSentecingPR.php
http://www.stopfraud.gov/iso/opa/stopfraud/NYS-121005.html

SEC Sues Kansas for Misleading Pension Liability Disclosures in Bond Offering Documents:
http://www.sec.gov/litigation/admin/2014/33-9629.pdf

See also SEC complaints against:
Illinois:
http://www.sec.gov/litigation/admin/2013/33-9389.pdf
New Jersey:
https://www.sec.gov/litigation/admin/2010/33-9135.pdf

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of August 16, 2014. 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 and/or Gary DeWaal 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.