Bridging the Week by Gary DeWaal

London Metal Exchange-approved warehouses and other foreign matters took the spotlight this past week in developments related to the financial services industry, including a surprise disclosure regarding a contentious international issue by the new Commodity Futures Trading Commission chairman. In addition, the International Swaps and Derivatives Association announced the agreement of 18 systemically important global banks to delay by one day their right to take certain adverse actions against one another in connection with OTC transactions when their swap counterparty is in imminent collapse and their fate is being resolved by a national regulator. And has anyone seen some missing Securities and Exchange Commission laptops?

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

• UK Court Authorizes LME to Proceed With Reform of Physical Warehouse Network;
• CFTC Chairman Suggests December 15 QCCP Drama Is Postponed at GMAC Meeting; Committee Reviews NDFs and Bitcoins;
• UK FCA Sanctions Two Former Directors for Brokerage Company’s Customer Protection Rule Violations;
• ISDA Announces Stay Agreement for Banks Too Big to Fail;
• Canadian-Based FCM Fined US $70,000 for One-Day Customer Funds Handling Mistake (includes Compliance Weeds);
• E*Trade Subsidiaries Fined by SEC for Selling Penny Stocks Through Unregistered Offerings;
• Hedge Fund Manager Sanctioned for Defrauding Investors by Hiding Madoff Losses and Theft;
• Former CBOT Floor Broker Fined US $200,000 by CFTC for Trading, Recordkeeping and Supervision Violations;
• Inspector General Reports Missing SEC Laptops Potentially Containing Confidential Information; and more.

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UK Court Authorizes LME to Proceed With Reform of Physical Warehouse Network:

The UK Court of Appeals held that the London Metal Exchange may proceed with a previously announced plan aimed at shortening the amount of time it takes to retrieve metal from exchange-approved warehouses. In doing so, the court set aside a lower court ruling on the matter.

During 2013, the LME was criticized for delivery delays from LME-approved warehouses that some claimed were artificially increasing the prices of certain LME-traded metals worldwide. (Click here for background on this matter in the article “FCA Issues Statement Regarding LME Warehouse” in the November 4 to 8 and 11, 2013 edition of Bridging the Week.)

In response, on November 7, 2013, the LME—after public consultation—proposed a rule that would link the amount of LME-traded metal an exchange-approved warehouse could accept for storage to the amount of the same metal it released whenever the warehouse could not process requests to discharge the same metal from storage in less than 50 days. (This proposal is known as the “LILO” rule, meaning the amount of metal loaded out of a warehouse is linked to the amount loaded in.)

United Company Rusal PLC, an aluminum producer, challenged the consultation process. The company claimed that the LME’s proposed rule would financially hurt producers like itself, and that the LME never adequately considered this potential harm, as it was required to do.

Rusal claimed that other alternatives, such as limiting the storage charges that warehouses could assess on stored metals beyond a certain number of days (a so-called “rent-ban option”), would also reduce the price of relevant metals (such as aluminum) without harming producers. The lower court sided with Rusal. (Click here for a summary of this legal decision in the article “UK High Court Sets Aside LME Proposed Rule Aimed to Reduce Waiting Time at Approved Warehouses to Withdraw Metals in Order to Reduce Aluminum Prices to Commercial Clients and Consumers” in the March 24 to 28 and 31, 2014 edition of Bridging the Week.)

Rusal also had argued that LME’s decision-making was biased “…since it is financed by a stock levy made by it on warehouse charges and thus had an interest in maintaining the amount of the rent charged by warehouse operators.”

In holding for the LME, the appellate court rejected Rusal’s claims and concluded that the exchange’s consultation process regarding the LILO rule was adequate. Although Rusal argued that the LME’s consideration of the rent-ban option during the exchange’s consultation was insufficient, the appellate court noted that Rusal had never advocated for this option before its lawsuit.

In response to the appellate court’s decision, LME announced it would proceed with a two-week consultation and expected to implement the LILO rule on February 1, 2015.

LME acknowledges that market conditions have changed since 2013, and that there is now a greater demand for metals, especially aluminum. However, the LME believes implementation of the LILO rule is still warranted:

[T]he LME also understands that an element of primary production continues to flow into storage—and, in the absence of regulation by the LME, it is to be expected that a significant element of such production would have continued to be loaded into [LME-approved warehouses]. …In particular, the LME believes that the behavioural change exhibited by [LME-approved warehouses] since 1 July 2013 would not have come about had those warehouses not anticipated the introduction of some form of rule-making by the LME.

CFTC Chairman Suggests December 15 QCCP Drama Is Postponed at GMAC Meeting; Committee Reviews NDFs and Bitcoins

The Commodity Futures Trading Commission hosted a meeting of its Global Markets Advisory Committee last week, chaired by Commissioner Mark Wetjen. The principal topics included when the Commission should begin mandating the clearing of foreign exchange-based nondeliverable forward contracts and unique regulatory issues presented by exchange-traded derivative contracts on Bitcoins.

Most surprising was an unrelated announcement by Chairman Timothy Massad during his opening remarks that European regulators have “decided to postpone the imposition of higher capital charges” on European banks that had been expected as of December 15. This  is because of European regulators’ failure, to date, to recognize US-based designated clearinghouses as so-called qualified central counterparties. No other details were given in Mr. Massad’s prepared comments.

In his opening statement, Mr. Wetjen observed that there are conflicting views regarding the timeliness of an NDF clearing mandate. However, whatever the decision regarding the timing of a clearing mandate, Mr. Wetjen urged that “the implementation of any such mandate … be aligned with any comparable mandates overseas.”  (Click here to see an article regarding the initiation of consultation by the European Securities and Markets Authority regarding NDF mandatory clearing in Europe, “ESMA Begins Consultation on Standards for FX Nondeliverable Forwards Clearing and Proposes Start Dates for Interest Rate Swaps Clearing,” in the September 23 to October 3 and 6 edition of Bridging the Week.)

Mr. Wetjen also observed that one Bitcoin-based derivatives contract has already been proposed by a swap execution facility (TeraExchange, LLC), and other registered and impending-registered platforms intend to list other Bitcoin-denominated contracts too. The discussion at the GMAC dealt with “regulatory challenges that these novel contracts present” as well as “potential benefits that Bitcoin or Bitcoin-like protocols and technology” might introduce to derivatives marketplaces.

Separately, TeraExchange announced last week that the first Bitcoin derivatives transaction had been executed on its trading platform involving a US dollar/Bitcoin swap. (Click here for details of this transaction. Click here for a related article, “Bitcoin: Current US Regulatory Developments” in a November 26, 2013 Corporate/Financial Services Advisory by Katten Muchin Rosenman LLP.)

UK FCA Sanctions Two Former Directors for Brokerage Company’s Customer Protection Rule Violations:

The UK Financial Conduct Authority announced sanctions against two former directors of Pritchard Stockbrokers Limited related to the firm’s mishandling of client assets. Pritchard was a UK-based firm designated by the FCA to carry on an investment business that was engaged in stock brokerage and wealth management businesses.

The two former directors were David Gillespie, the company’s former managing director, and David Welsby, the firm’s former finance director.

According to the FCA, Pritchard experienced financial problems since 2009. The FCA claimed that “[t]hese financial problems put pressure on Pritchard’s capital adequacy and client money positions and resulted in Pritchard using client money to meet business expenses.” FCA claimed that from July 1, 2010, through February 8, 2012, except for two days, Pritchard had significant shortfalls in client money. In response, Mr. Gillespie allegedly obtained an undocumented GBP 2 million (US $3.2 million) offshore facility to buttress the firm’s client money position. However, this offshore facility was impermissibly included as an available client money resource by Pritchard and Messrs. Gillespie and Welsby.

Because of concerns regarding Pritchard’s handling of client funds, the FCA began a process on February 10, 2012, to secure the firm’s assets and close out existing transactions. By March 2012, the firm had entered a “special administration”—somewhat analogous to a US bankruptcy proceeding.

To resolve this matter Mr. Gillespie and Mr. Welsby agreed to financial penalties of GBP 10,500 and GBP 14,000 (US $16,876 and US $22,500), respectively—reduced amounts in light of their “verifiable evidence of serious financial hardship”—and to be barred from ever being involved in an FCA-regulated activity. Pritchard would have been subject to a financial penalty of almost GBP 5 million (over US $8 million) said the FCA. However, the FCA determined that, given the financial situation of the firm, any funds should be made available to creditors and “decided not to impose a financial penalty upon it.”

And briefly:

• ISDA Announces Stay Agreement for Banks Too Big to Fail: Eighteen systemically important global banks have agreed to delay their right to exercise certain early termination and cross-default rights against one another in connection with over-the-counter transactions when their counterparty is in imminent collapse and their fate is being resolved by a national regulator. This agreement was developed by the International Swaps and Derivatives Association, Inc. in conjunction with the Financial Stability Board, and will be memorialized in a new “ISDA Resolution Stay Protocol.” The protocol, which will effectively amend standard ISDA form derivatives contracts between the banks–all deemed "too big to fail"–is expected to be formally implemented in November and go into effect as of January 1, 2015. The adoption of the protocol is anticipated to enhance the effectiveness of cross-border resolution actions. Currently, statutory stays that might be obtained by regulators to delay implementation of early termination rights may only apply domestically. According to a statement issued by the FSB,“[w]hen the protocol goes live in November, it will close off much of the cross-border close-out risk that statutory stays have not been able to eliminate because their reach is limited to national borders.” (The FSB was established following the 2008 financial crisis to coordinate internationally national regulators and international standard setting bodies.)
   
• Canadian-Based FCM Fined US $70,000 for One-Day Customer Funds Handling Mistake: Friedberg Mercantile Group, Inc.—a Canadian-based registered futures commission merchant—was fined US $70,000 by the Commodity Futures Trading Commission for having an insufficient amount of funds in its so-called “customer secured account” origin on one day, and for not reporting to the CFTC its deficiency on the same day, as required. According to the CFTC, on February 5, 2013, a Friedberg Mercantile customer requested a transfer of US $300,000 from its so-called segregated account (to support US futures and options) to its secured account (to support non-US futures and options) to cover a margin call. As a result of some erroneous attempted transfers of funds to accommodate the client’s request, the firm had insufficient funds in its customer secured account origin to meet its secured funds obligations to its customers. The following day, to fix this matter, the firm moved funds from its segregated customer account at its bank to its house account there, and then from its house account to its customer secured omnibus account at its carrying firm. However this commingling of customer segregated and house funds in the firm’s house account was also improper, said the Commission. Friedberg Mercantile also did not provide notice to the CFTC of its February 5 customer secured funds deficiency until February 14, instead of on February 5, as required, said the CFTC. Friedberg Mercantile consented to the terms of its sanction.

Compliance Weeds. This is the latest in a series of CFTC enforcement actions related to violations of its customer protection rules. The CFTC has indisputably put the industry on notice that, no matter what the cause or duration—even if the error was clearly clerical, it will sanction registrants for infractions. At a minimum, FCMs should augment their checks and balances to detect potential customer protection rules violations and regularly review their processes to help ensure that no prior mistakes have been made.

• E*Trade Subsidiaries Fined by SEC for Selling Penny Stocks Through Unregistered Offerings: Two subsidiaries of E*Trade Financial Corporation—E*Trade Securities, LLC and G1 Execution Service, LLC—were sanctioned by the Securities and Exchange Commission for permitting three unnamed customers to sell to the public newly issued penny stocks that previously had been deposited in their E*Trade accounts. The customers made their sales without any registration statements for the securities being in effect. (Distributions of securities without registration statements or a valid exemption being in effect are unlawful.) According to the SEC, at various times between March 2007 and April 2011, the E*Trade companies failed to conduct appropriate due diligence to identify a lawful exemption that might be in place, and as a result facilitated the unlawful sale of penny stocks of approximately 247 different companies. Moreover, the E*Trade companies are alleged to have missed several red flags which the SEC claims should have “raised a question as to whether these customers were engaged in an unlawful distribution.” These red flags included that “(1) the three customers acquired substantial amounts of newly issued penny stocks; (2) directly from little known, non-reporting issuers; (3) through private, unregistered transactions; (4) then immediately resold those shares; and (5) wired out the sales proceeds.” The E*Trade companies agreed to settle this matter by remitting an aggregate penalty of US $1 million and paying back more than US $1.5 million in disgorgement and interest from the impermissible sales. (G1 Execution Services was sold earlier in 2014 to a third party.) Concurrently with issuance of this settlement, the SEC published a Risk Alert and Frequently Asked Questions related to obligations of broker-dealers in connection with unregistered transactions for their customers. (Click here for more information on this Risk Alert and FAQs in the article “SEC Issues Risk Alert and FAQs on Customer Sales of Unregistered Securities” in the October 10 edition of Corporate & Financial Weekly Digest by Katten Muchin Rosenman LLP.)
   
• Hedge Fund Manager Sanctioned for Defrauding Investors by Hiding Madoff Losses and Theft: A federal judge ordered Nikolai Battoo and two companies he controlled, BC Capital Group S.A. (Panama) and BC Capital Group (Hong Kong) Limited, to pay a civil penalty of US $68 million and disgorgement and interest in excess of US $290 million related to an allegedly fraudulent scheme perpetrated on investors beginning in 2008. According to the SEC, Mr. Battoo was a hedge fund manager who claimed “exceptional risk-adjusted returns” and, through his BC entities, raised over US $400 million from investors by 2012. The SEC claimed that Mr. Battoo incurred major losses by 2008 because of a failed derivatives investment program and losses in Bernard Madoff funds. He also stole at least US $49 million of investor funds “so that he could live the high life during his scheme,” the SEC said. The SEC filed its complaint against Mr. Battoo and the two BC entities in 2012. The Commodity Futures Trading Commission also charged Mr. Battoo and four companies he controlled with fraud in 2012.
   
• Former CBOT Floor Broker Fined US $200,000 by CFTC for Trading, Recordkeeping and Supervision Violations: Kent Woods, a long time floor broker on the Chicago Board of Trade, and an associated person and principal of Futures International, Inc., an introducing broker, was charged by the Commodity Futures Trading Commission in an administrative proceeding with failing to comply with applicable recordkeeping requirements in connection with customer orders he executed from at least January 2009 to at least November 2012. According to the Commission, during this time, Mr. Woods routinely failed to obtain or record order instructions from his customers in the form required by CFTC rules. Because Mr. Woods filled orders where he did not have a specific customer order or a formal power of attorney, his trading constituted the exercise of discretion that was unauthorized, claimed the Commission. In addition, the CFTC alleged that Futures International’s staff and Mr. Woods routinely created a false audit trail of customer orders by using pre-stamped order tickets to reflect orders and fills after execution. For these violations, Mr. Woods was also charged with engaging in unauthorized trades and failure to supervise. He agreed to settle this matter by payment of a fine of US $200,000 and restrictions for two years on the way he places or executes non-electronic orders. Separately, the CFTC charged Futures International and Amadeo Cerrone, its chief operating officer, for similar violations in a federal court in Chicago.

And even more briefly:

• Japan SESC Files Spoofing Action: The Japan Securities and Exchange Surveillance Commission announced it had filed charges with the Tokyo District Public Prosecutors Office against two unnamed suspects for allegedly engaging in spoofing activities related to four publicly traded equities. According to SESC, “The two suspects conspired to purchase and sell the shares, with the aim of raising the share prices to gain profits.”

• Unnamed Senior Banker Pleads Guilty in UK to LIBOR Offense: An unnamed “senior banker” pleaded guilty to conspiracy to defraud in connection with his alleged manipulation of the London Interbank Offered Rate. This plea arises out of the UK’s Serious Fraud Office’s ongoing investigation of LIBOR manipulation in conjunction with the UK Financial Conduct Authority and the US Department of Justice. Eleven other individuals have been charged by SFO and await trial.

• NYSE to Resume Market Surveillance, Investigation and Enforcement Functions: NYSE Group announced last week that NYSE Regulation would take over market surveillance, investigation and enforcement activities for NYSE Group’s equities and options exchanges from the Financial Industry Regulatory Authority as of January 1, 2016. The IntercontinentalExchange Group, Inc. acquired NYSE Euronext in November 2013.
   
• Basel Committee Issues FAQs of Leverage Ratio Framework: The Basel Committee on Banking Supervision has responded to various questions to its Basel III leverage ratio framework published in January 2014 in a newly issued Frequently Asked Questions. The FAQs include questions and answers related to the standards for recognizing cash variation margin associated with derivative exposures and centrally cleared client derivative exposures, among other topics.

• Three Senators Criticize CFTC’s Brian Hunter Settlement: Three US Senators—Maria Cantwell, Dianne Feinstein and Carl Levin—penned a letter to Commodity Futures Trading Commission Chairman Timothy Massad, complaining about the recent CFTC settlement with Brian Hunter, a former trader at Amaranth Advisors, LLC. Last month, the CFTC settled an enforcement action against Mr. Hunter related to his involvement in an alleged attempted manipulation of natural gas futures contracts on two days in 2007 for payment of a fine of US $750,000. The three senators termed the settlement “an embarrassment” for being too low. (Click here for details regarding this settlement and the underlying charges in the article “CFTC Settles Attempted Manipulation Case With Brian Hunter for Payment of US $750,000 Fine” in the September 15 to 19 and 22, 2014 edition of Bridging the Week.)

And finally:

• Inspector General Reports Missing SEC Laptops Potentially Containing Confidential Information: The Securities and Exchange Commission’s Office of Inspector General issued an audit report that claimed that over 200 laptop computers in locations it reviewed in test work may be missing, and as a result, “the SEC is at risk for the unauthorized release of sensitive, nonpublic information.” In addition, the Inspector General found numerous examples of incorrect internal location and user information related to laptops, and that the SEC’s procedures for “sharing information about lost or stolen laptops were inadequate.” According to the audit report, “[t]hese weaknesses existed because personnel did not always understand their roles and responsibilities, and related policies and procedures were inadequate, had not been effectively communicated, and were not consistently followed.” The SEC committed to implement various controls recommended by the Inspector General to improve its oversight of laptops.

For more information, see:

Basel Committee Issues FAQs of Leverage Ratio Framework:
http://www.bis.org/publ/bcbs293.pdf

Canadian-Based FCM Fined US $70,000 for One-Day Customer Funds Handling Mistake:
http://www.cftc.gov/ucm/groups/public/@lrenforcementactions/documents/legalpleading/enffriedbergorder100814.pdf

CFTC Chairman Suggests December 15 QCCP Drama Is Postponed at GMAC Meeting; Committee Reviews NDFs and Bitcoins:
http://www.cftc.gov/PressRoom/SpeechesTestimony/massadstatement100914

See also
GMAC Meeting Opening Remarks of Commissioner Mark Wetjen:
http://www.cftc.gov/PressRoom/SpeechesTestimony/wetjenstatement100914

E*Trade Subsidiaries Fined by SEC for Selling Penny Stocks Through Unregistered Offerings:
http://www.sec.gov/litigation/admin/2014/33-9662.pdf

See also SEC FAQs on Broker-Dealer Obligations in Connection With Unregistered Transactions:
http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370543133529#.VDc4Jr5vl_g

Former CBOT Floor Broker Fined US $200,000 by CFTC for Trading, Recordkeeping and Supervision Violations:
http://www.cftc.gov/ucm/groups/public/@lrenforcementactions/documents/legalpleading/enfwoodsorder100814.pdf

See also, CFTC v. Futures International LLC and Amadeo Cerrone:
http://www.cftc.gov/ucm/groups/public/@lrenforcementactions/documents/legalpleading/enfcerronecomplaint100914.pdf

Hedge Fund Manager Sanctioned for Defrauding Investors by Hiding Madoff Losses and Theft:

SEC v. Battoo (Order):
/ckfinder/userfiles/files/Battoo.pdf
Press release:
http://www.sec.gov/litigation/litreleases/2014/lr23104.htm

See also CFTC v. Battoo et al:
http://www.cftc.gov/ucm/groups/public/@lrenforcementactions/documents/legalpleading/enfbattoocomplaint090612.pdf

Inspector General Reports Missing SEC Laptops Potentially Containing Confidential Information:
http://www.sec.gov/oig/reportspubs/524.pdf

ISDA Announces Stay Agreement for Banks Too Big to Fail:
http://www2.isda.org/news/major-banks-agree-to-sign-isda-resolution-stay-protocol

See also FSB Statement:
http://www.financialstabilityboard.org/press/pr_141011.htm

Japan SESC Files Spoofing Action:
http://www.fsa.go.jp/sesc/english/topics/index.htm

NYSE to Resume Market Surveillance, Investigation and Enforcement Functions:
http://ir.theice.com/investors-and-media/press/press-releases/press-release-details/2014/NYSE-Regulation-to-Perform-Market-Surveillance-Investigation-and-Enforcement-Program-for-NYSE-Group-Exchanges/default.aspx

Three Senators Criticize CFTC’s Brian Hunter Settlement:
http://www.feinstein.senate.gov/public/index.cfm/files/serve/?File_id=4174fa56-9c77-4dc2-bcf0-8748d9cdd8a0

UK Court Authorizes LME to Proceed With Reform of Physical Warehouse Network:

United Company Rusal v. The London Metal Exchange:
/ckfinder/userfiles/files/LMEvRusalCoA.pdf
LME Press Release
https://www.lme.com/~/media/files/notices/2014/2014_10/14%20298%20a290%20w142%20-%20proposed%20implementation%20of%20the%20lilo%20rule.pdf

UK FCA Sanctions Two Former Directors for Brokerage Company’s Customer Protection Rule Violations:

David Gillespie:
http://www.fca.org.uk/static/documents/final-notices/david-gillespie.pdf
David Welsby:
http://www.fca.org.uk/static/documents/final-notices/david-welsby.pdf
Pritchard Stockbrokers Limited
http://www.fca.org.uk/static/documents/final-notices/pritchard-stockbrokers.pdf

Unnamed Senior Banker Pleads Guilty in UK to LIBOR Offense:
http://www.sfo.gov.uk/press-room/latest-press-releases/press-releases-2014/libor-manipulation-banker-pleads-guilty-to-conspiracy-to-defraud.aspx

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of October 11, 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.