Bridging the Week by Gary DeWaal

The Securities and Exchange Commission proposed a rule that, if adopted, would restrict registered investment funds from transacting in derivatives. In France, one algorithmic trader and an exchange were sanctioned for certain high-speed trading activities; while in Canada, high-speed trading was initially praised by a regulator. However, later on the same day, the praise was retracted, but certain beneficial impacts on markets by high-speed trading continued to be itemized. As a result, the following matters are covered in this week’s edition of Bridging the Week:

• SEC Considers New Rule to Restrict Use of Derivatives by Investment Companies;
• Energy Trading Firm Pays US $3.6 Million Fine to Resolve CFTC Charges of Attempted Manipulation of Index Settlement Price;
• French AMF Fines Exchange and Trader €5 Million Each for Alleged Disruptive Trading;
• Appellate Court Vacates Criminal Conviction of Mortgage-Backed Securities Trader Convicted of Lying to Customers;
• Brokerage Company Fined and Required by NFA to Withdraw FCM Registration for Inadequate Risk Management Program (includes Compliance Weeds);
• Canadian Regulator Concludes No Issues With High Frequency Trading After Initially Saying Impact “Mostly Positive;”
• ICE Futures U.S. Sanctions Two FCMs for Misreporting Open Interest, and Another for Misreporting EFRPs (includes Compliance Weeds); and more.

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SEC Considers New Rule to Restrict Use of Derivatives by Investment Companies:

The Securities and Exchange Commission proposed a new rule aimed at limiting the leverage registered investment companies could obtain through the use of derivatives transactions.

In addition, the SEC’s proposed new rule would require investment companies to set aside in segregation qualifying assets to meet their mark-to-market liability as well as to cover potential future losses on derivatives transactions. Also, investment companies would be required to establish a formalized risk management program to manage the risks of derivatives transactions if they engaged in more than a limited number of  transactions.

Investment companies would also be required to segregate certain assets in connection with other transactions that have a potential deferred financial obligation, such as repurchase agreements and short sales—termed “financial commitment transactions.” For such transactions, an investment company would be required to separately set aside qualifying assets with a value equal to the total amount of cash or other assets it must or conditionally might have to pay to satisfy its obligations.

Investment companies include mutual funds, exchange-traded funds—so-called ETFs—, and closed-end funds (collectively, "funds"). Derivatives include swaps, security-based swaps, futures contracts, forward contracts, options and similar type instruments where a fund is or might be required to make payments or deliver cash or other assets during the life of the instrument or at any future time, whether as margin, settlement or otherwise.

Under applicable law, a fund is limited in its ability to borrow money or issue senior securities. The SEC considers the use of derivatives as generally implicating this provision:

where [a] fund has entered into a derivatives transaction and has a future payment obligation—a conditional or unconditional contractual obligation to pay in the future—we believe that such a transaction involves an evidence of indebtedness that is a senior security for purposes of [applicable law].

(Click here to access the relevant law, Section 18 of the Investment Company Act, 15 US Code § 80a-18.)

SEC Chair Mary Jo White explained her unease regarding the status quo in approving issuance of the proposed new rule:

I am concerned about the potential for ...losses under the current regulatory framework. Today, funds can obtain high levels of exposure through the current practice of “mark-to-market segregation,” where a fund only segregates liquid assets equal to the current liability, if any, of a derivative transaction… This practice also raises concerns that a fund may not have sufficient liquid assets to meet potential future losses because a fund may only maintain liquid assets to cover losses that the fund has already incurred.

Under the SEC’s proposed new rules, a fund would have to comply with one of two leverage restrictions in connection with its derivatives transactions—an exposure-based position limit or a risk-based portfolio limit. Under the former limit, a fund would have to limit its aggregate exposure to 150 percent of its net assets (based on the notional amount of its derivatives transactions). Alternatively, a fund could obtain exposure to derivatives up to 300 percent of its assets provided the fund also satisfied a risk-based test. The greater potential leverage would be justified under this alternative test, said the SEC, because the fund’s portfolio would presumably be subject to less market risk by including derivatives than by not.

A fund would also have to separately segregate qualifying assets equal to an amount it would have to pay to exit the derivatives transaction at the time of the determination (so-called "mark-to-market coverage amount") plus an additional amount derived from a reasonable estimate of what the fund might have to pay to liquidate its derivatives transactions under stressed circumstances (so-called "risk-based coverage amount").

Finally, a fund that undertook more than a limited number of derivatives transactions or used complex derivatives would have to maintain a formalized risk management program under the oversight of a designated risk manager. The program would have to be “reasonably designed” to assess, manage and monitor the risks of derivatives transactions and to segregate functions of relevant personnel. Formalized risk programs would require annual updates and reviews.

Funds’ board of directors — including a majority of disinterested directors — would have to approve a registered fund’s risk management program and any material changes, as well as the designation of the derivatives risk manager.

The SEC also proposed amendments to funds’ reporting obligations that would require them to disclose to the Commission on a monthly and yearly basis certain information regarding their derivatives’ use.

In issuing a dissenting statement in connection with the Commission’s issuance of its proposed new rule, Commissioner Michael Piwowar claimed that the proposed limits on leverage were unnecessary. This is because, he said,

the proposed asset segregation requirements should function as a leverage limit on funds and ensure that funds have the ability to meet their obligations arising from derivatives. Therefore, absent data indicating that a separate specified leverage limit is warranted, there is no justification for imposing any additional requirements or burdens on funds.

The SEC will accept comments on its proposed new rule for 90 days after their publication in the Federal Register.

Briefly:

• Energy Trading Firm Pays US $3.6 Million Fine to Resolve CFTC Charges of Attempted Manipulation of Index Settlement Price: Total Gas & Power North America, Inc. and Therese Tran, a natural gas trading and marketing firm and one of its traders, were charged by the Commodity Futures Trading Commission with attempting to manipulate natural gas monthly index settlement prices during four monthly periods in 2011 and 2012. The firm and trader settled the CFTC’s charges, without admitting or denying any of the Commission’s findings or conclusions, by agreeing to pay a fine of US $3.6 million and a two-year prohibition on certain trading activity. According to the CFTC, TGPNA traded a very high volume of fixed-price natural gas contracts during the last week of September 2011, October 2011, March 2012 and April 2012 without any apparent commercial need. This was done, alleged the CFTC, solely to influence the settlement of TGPNA’s related financial basis and index swaps that were priced off the volume-weighted average price of all reported fixed-price transactions occurring during the month-end periods. In September 2014, the Federal Energy Regulatory Commission issued a notice saying it was also investigating TGPNA, Ms. Tran and Aaron Hall, another TGPNA trader, to assess whether they devised and executed “a scheme to manipulate the price of natural gas in the southwest United States between June 2009 and June 2012.” In its complaint against TGPNA, the CFTC also claimed that the firm's attempted manipulation constituted a prohibited employment of a manipulative device under the Commission's relatively new Dodd-Frank authority.
   
• French AMF Fines Exchange and Trader €5 Million Each for Alleged Disruptive Trading: The French financial regulator, Autorité des Marchés Financiers, announced that it had penalized both Virtu Financial Europe and Euronext Paris €5 million over certain of Virtu’s trading activities in 2009. According to the AMF, during the relevant time, Virtu very rapidly placed and cancelled orders in 27 securities that “distorted the representation of the order books for market participants” and constituted market manipulation under applicable AMF regulation. During the relevant time, said AMF, Virtu’s trades constituted 62.7 percent of all messages but only 2 percent of all trades, while 66 percent of the firm’s orders lasted less than one second and 25 percent lasted less than 10 milliseconds. AMF claimed that Euronext permitted Virtu’s violation by exempting the firm from its then prevailing maximum permitted daily ratio of orders placed to number of trades—100 to 1. According to AMF, through its conduct, Euronext did not operate “with neutrality and impartiality in accordance with market integrity.” In response, Euronext issued a press release claiming that AMF’s fine was “totally disproportionate and completely anachronistic” and that it would appeal. Euronext implied that Virtu’s trading was consistent with a pilot program that was reviewed by AMF and ended in 2010. In its decision, AMF acknowledged that Virtu’s “trading strategy in itself nor its status as a high-frequency trader were in question.”
   
• Appellate Court Vacates Criminal Conviction of Mortgage-Backed Securities Trader Convicted of Lying to Customers: A US federal appeals court in New York vacated the criminal conviction of Jesse Litvak, a former securities broker and trader at Jefferies & Company, for making material misstatements to several of Jefferies’ counterparties—including certain private public investment funds—in connection with their purchases and sales of residential mortgage-backed securities between 2009 and 2011. (PPIFs are financial vehicles to purchase pools of loans, securities or other assets from a financial institution, funded in part by private investors, and in part by funds provided by the Department or Treasury or other government-appropriated funds.) In an indictment filed against him in January 2013, Mr. Litvak was charged with securities fraud, fraud against the United States and making false statements, and convicted on all but one count following a jury trial in a US trial court in February and March 2014. Mr. Litvak promptly filed an appeal. The appellate court reversed the trial court’s conviction of charges of making false statements and fraud against the United States as it concluded that Mr. Litvak could not have made any statements that were materially false to the United States. This is because the Department of Treasury had no legal authority to make purchase decisions for the PPIF clients. Thus, Mr. Litvak’s alleged misstatements had no ability to influence a decision of the Department of Treasury to invest — a pre-requisite to his conviction, said the appellate court. In addition, the appellate court vacated Mr. Litvak’s conviction on the securities fraud counts, claiming that the trial court improperly excluded certain testimony of expert witnesses on behalf of Mr. Litvak. Mr. Litvak was sentenced to two years in prison and required to pay a US $1.75 million fine following his conviction.
   
• Brokerage Company Fined and Required by NFA to Withdraw FCM Registration for Inadequate Risk Management Program: X-Change Financial Access LLC, a futures commission merchant registered with the Commodity Futures Trading Commission and a member of the National Futures Association, agreed to withdraw its FCM registration and operate solely as an introducing broker, to settle charges brought by the NFA that it failed to maintain an adequate risk management program, in violation of the applicable CFTC rule. (Click here to access CFTC Rule 1.11 and here to access NFA Rule 2-26, which incorporates CFTC Rule 1.11 by reference.) According to NFA, beginning in April 2013, NFA recommended to XFA that it enhance its risk monitoring of its customers to anticipate its potential exposure in the event of an extreme market move. From then through 2015, claimed NFA, the firm proposed various measures to improve its risk monitoring as well as adopted procedures to better protect itself from higher-risk accounts. However, according to NFA, the firm never uniformly implemented or consistently followed its proposed or written procedures. Following this failure, in August 2015, XFA had large margin calls that exceeded the firm’s segregated funds, and necessitated the firm to obtain loans and capital infusions from its principals. The NFA claimed that George Stafford, the firm’s chief compliance officer and risk manager “indicated that XFA was not monitoring” three accounts that accounted for a significant portion of the large margin calls. The three accounts currently owe $1.1 million to XFA. To resolve this matter, XFA also agreed to pay a fine to NFA of US $75,000. NFA additionally charged Peter Scheffler, XFA’s co-CEO and Mr. Stafford in connection with this matter; however, they did not incur any personal sanctions as part of the settlement.

Compliance Weeds: Under the applicable Commodity Futures Trading Commission regulation, a futures commission merchant that carries customer accounts must implement, maintain and enforce risk management policies and procedures designed (not just reasonably designed) to monitor and manage the risks associated with its business. Among other things, the risk program of an impacted FCM must address certain elements: identification of risks that the FCM routinely confronts, including risks posed by affiliates, and risk tolerance limits; periodic risk exposure reports; and certain specific risks—segregation risk, operational risk and capital risk. There must be a risk management unit reporting directly to senior management “with specific authority; qualified personnel; and financial, operational and other resources to carry out the FCM’s risk management program.” The risk management unit must provide senior management and the FCM’s governing body with a quarterly written report describing all applicable risk exposures; recommended or completed changes to the risk program; and incomplete implementation of previously recommended changes. These reports must also be issued “immediately upon detection of any material change” in the FCM’s risk exposure. All risk exposure reports must be provided to the CFTC within five business days of giving such reports to senior management. Finally, risk tolerance levels must also be reviewed and approved quarterly by senior management and annually by the FCM’s governing body.

• Canadian Regulator Concludes No Issues With High Frequency Trading After Initially Saying Impact “Mostly Positive”: The Investment Industry Regulation Organization of Canada, a self-regulatory organization, completed a study of high-frequency trading that “did not reveal any concerns that warranted a regulatory response beyond measures already implemented by IIROC.” When IIROC initially issued its study on December 9, 2015, it noted “that the presence of HFT has different, mostly positive impacts on Canadian equity markets and those who invest on those markets.” Later the same day, IIROC reissued its statement accompanying its study, deleting the words “mostly positive,” but leaving all other language intact. IIROC’s study concluded that HFTs generally provide more liquidity and contribute “substantially” to price discovery, and that the “majority of passive orders entered by HFT[s] either improve the best price or match the prevailing best prices.” IIROC also found that “[t]here is little evidence” that HFTs front-run or otherwise take advantage of slower traders. IIROC’s study examined the impact of HFTs on Canada’s equity markets.
   
• ICE Futures U.S. Sanctions Two FCMs for Misreporting Open Interest, and Another for Misreporting EFRPs: Two clearing members settled charges with ICE Futures U.S. that they allegedly failed to report open interest accurately. Credit Suisse Securities (USA) LLC agreed to pay a fine of US $30,000 to resolve a charge that, on two days in 2014, it misreported open interest in the May 2014 cocoa futures contract; while Wells Fargo Securities LLC agreed to pay a fine of US $10,000 for purportedly incorrectly reporting open interest in the Henry Penultimate Fixed Price Future on the last trading day for the contract on “multiple instances.” RJ O’Brien agreed to pay a fine of US $50,o00 as well as underpaid fees of $21,278 to resolve charges brought by IFUS that it allegedly failed to use the exchange’s ICEBlock application to post certain EFP transactions. Instead, the firm used a different exchange system. Finally, CME Group fined Yongwen Shao, a non-member, US $85,000 and permanently barred him from trading CME Group products for entering into 19 round-turn transactions from November 2009 to November 2010 and during March 2010, to transfer $35,700 from accounts of two other persons to his own trading account. Mr. Shao did not participate in the exchange’s investigation of, or answer the exchange’s charges brought against, him.

Compliance Weeds: ICE Clear U.S. rules require each clearing member to report to it by 7:30 p.m. each business day its open interest in each contract. Other times may apply during notice periods. Adjustment must be reported to ICE Clear ordinarily by 9 a.m. the following business day. (Click here to access the relevant ICE Clear rule 403.) ICE Futures U.S. may have additional rules regarding open interest reporting. (Click here, for example, to access IFUS Rule 18.05 regarding open interest in energy contracts.)

And more briefly:

• Eurex Augments Anti-Market Disruption Rules: Eurex Deutschland and Eurex Zurich AG have amended their market integrity rule to affirmatively require algorithmic trades to ensure that their systems won’t disrupt “orderly futures and options trading.” They have also amended the same rule to prohibit trading participants from entering orders or quotes into Eurex systems “unless they intend to conclude a business transaction.”
   
• HK SFC Mandates Suitability Clause in All Client Agreements of Members, Including for Futures: The Hong Kong Securities and Futures Commission will require all regulated intermediaries to include a new clause in their client agreements—including those dealing with futures—stating that “[i]f we [the intermediary] solicit the sale of or recommend any financial product to you [the client], the financial product must be reasonably suitable for you having regard to your financial situation, investment experience and investment objectives,” as well as other language. The new language must be included in all agreements by June 9, 2017, although SFC expects intermediaries will comply beforehand.
   
• Ex-Enron Head Permanently Barred From Serving as Officer or Director of Publicly Traded Companies: The Securities and Exchange Commission announced that it had obtained an order from a federal court permanently barring Jeffrey Skilling from ever serving as an officer or director of a publicly traded company. In 2006, Mr. Skilling was convicted of federal charges related to the collapse of Enron Corporation. He is currently imprisoned.
   
• CFTC Extends Taping Relief to CTA Members of Exchanges: The Commodity Futures Trading Commission extended no-action relief from certain recordkeeping requirements to commodity trading advisors who are members of designated contract markets or swap execution facilities. Under the no-action relief, impacted CTAs do not have to record oral communications or link records of oral and written communications that lead to the execution of a transaction. This relief is indefinite in duration until replaced by an amendment to the CFTC’s recordkeeping requirements that incorporates it.
   
• Forget the Test — NFA to Solely Require Training; No Series 3 Module Change for Security Futures Personnel: The National Futures Association advised the Commodity Futures Trading Commission that it will not amend its Series 3 examination to include a module on security futures products, as initially contemplated in 2001. Instead it will require registrants to take a training program on SFPs instead. Given low trading volumes of SFPs, NFA said, “implementing a testing requirement does not appear to be the most practical solution at this time.”
   
• FINRA Members Must Include Obvious Link to BrokerCheck on Websites by Mid-2016: The Financial Industry Regulatory Authority is requiring all broker dealers who intend their website to be viewed by a retail person to include a “readily apparent reference and hyperlink” to FINRA’s BrokerCheck by June 6, 2016. This reference and hyperlink must appear on the BD’s initial webpage, as well as any webpage that includes a “professional profile” of one or more registered persons that deal with retail persons. (Under FINRA rules, a retail investor is anyone other than an institutional investor. Click here to access FINRA’s definition of institutional investor.)

For more information, see:

Appellate Court Vacates Criminal Conviction of Mortgage-Backed Securities Trader Convicted of Lying to Customers:
/ckfinder/userfiles/files/Litvak%20Appeal.pdf

See also, Press Release Related to Jesse Litvak Sentencing:
http://www.justice.gov/usao-ct/pr/former-rmbs-trader-sentenced-prison

Brokerage Company Fined and Required by NFA to Withdraw FCM Registration for Inadequate Risk Management Program:
Complaint:
https://www.nfa.futures.org/basicnet/CaseDocument.aspx?seqnum=4239
Decision:
https://www.nfa.futures.org/basicnet/CaseDocument.aspx?seqnum=4264

Canadian Regulator Concludes No Issues With High Frequency Trading After Initially Saying Impact “Mostly Positive:

Revised Press Release:
http://www.iiroc.ca/Documents/2015/555b7856-7b49-44ee-81de-bdb7c2c0c9ce_en.pdf

Summary of Initial Press Release:

IIROC completes comprehensive study of High Frequency Trading
Canada NewsWire (press release)-Dec 9, 2015
The Investment Industry Regulatory Organization of Canada (IIROC) ... the presence of HFT has different, mostly positive impacts on Canadian ... In the first two stages of the three-phase HFT study, IIROC identified ... This High Order-to-Trade (HOT) study was published by IIROC in December 2012.

Completion of Final Phase:
http://docs.iiroc.ca/DisplayDocument.aspx?DocumentID=1DAAC865AB9B4BA79E7EFD1588DB2B5E&Language=en

CFTC Extends Taping Relief to CTA Members of Exchanges:
http://www.cftc.gov/idc/groups/public/@lrlettergeneral/documents/letter/15-65.pdf

Energy Trading Firm Pays US $3.6 Million Fine to Resolve CFTC Charges of Attempted Manipulation of Index Settlement Price:
http://www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfnorthamerorder12715.pdf

See, also, FERC Notice of Alleged Violations:
http://www.ferc.gov/enforcement/alleged-violation/notices/2015/TGPNA-NAV.pdf

Ex-Enron Head Permanently Barred From Serving as Officer or Director of Publicly Traded Companies:
http://www.sec.gov/litigation/litreleases/2015/lr23422.htm

Eurex Augments Anti-Market Disruption Rules:
https://www.eurexchange.com/blob/2292104/431d03ffbbcc3a53cbfe8da6e19deb8e/data/er15217e.pdf

FINRA Members Must Include Obvious Link to BrokerCheck on Websites by Mid-2016:
https://www.finra.org/sites/default/files/Notice_Regulatory_15-50.pdf

Forget the Test — NFA to Solely Require Training; No Series 3 Module Change for Security Futures Personnel:
https://www.nfa.futures.org/news/PDF/CFTC/InterpNotc_CR2-7_2-2_RR401_ProficiencyRequirements_for_SFPs_Nov2015.pdf

French AMF Fines Exchange and Trader €5 Million Each for Alleged Disruptive Trading:
http://www.amf-france.org/en_US/Actualites/Communiques-de-presse/Comission-des-sanctions.html?docId=workspace%3A%2F%2FSpacesStore%2Fd83d375f-f736-40d0-9412-f722decfb4cc

See, also, Euronext Press Release:
https://www.euronext.com/en/news/euronext-appeal-ruling-amf-enforcement-committee

HK SFC Mandates Suitability Clause in All Client Agreements of Members, Including for Futures:
http://www.sfc.hk/edistributionWeb/gateway/EN/news-and-announcements/news/doc?refNo=15PR120

ICE Futures U.S. Sanctions Two FCMs for Misreporting Open Interest, and Another for Misreporting EFRPs:

CME Group:
http://www.cmegroup.com/tools-information/lookups/advisories/disciplinary/NYMEX-13-9416-BC-3-YONGWEN-SHAO.html
ICE Futures U.S.:
Credit Suisse:
/ckfinder/userfiles/files/Credit%20Suisee%20IFUS.pdf
RJO’Brien:
/ckfinder/userfiles/files/RJO%20IFUS.pdf
Wells Fargo:
/ckfinder/userfiles/files/Wells%20Fargo%20IFUS.pdf

SEC Considers New Rule to Restrict Use of Derivatives by Investment Companies:
http://www.sec.gov/rules/proposed/2015/ic-31933.pdf

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of December 12, 2015. 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.