Bridging the Week by Gary DeWaal

Last week a non-US broker was sanctioned by the Commodity Futures Trading Commission for purportedly dealing with two institutional US customers without being registered as a futures commission merchant or exempt from registration. In the United States, a broker-dealer was sanctioned for alleged breakdowns in its compliance with Securities and Exchange Commission rules regarding short sales. Also, industry organizations tried to help the court in a CFTC enforcement action by pointing out that the CFTC is trying to use an incorrect standard to prove a charge of attempted manipulation. I also review Billions, the new Showtime serial drama about a fictional US Attorney and a highly successful hedge fund manager. As a result, the following matters are covered in this week’s edition of Bridging the Week:

• Non-US Broker Fined by CFTC for Soliciting Futures Orders and Handling Funds for Two US Customers Without Registration or an Exemption (includes Compliance Weeds);
• Broker-Dealer Fined US $15 Million for Short Sales Deficiencies;
• Industry Groups Seek to Help Court Hearing the CFTC Enforcement Action Against DRW Regarding What Constitutes Attempted Manipulation (includes Legal Weeds);
• Et Tu, SEC? – SEC OCIE Announces 2016 Examination Priorities (includes Compliance Weeds);
• Basel Banking Committee Issues Revised Framework for Risk Capital Requirements;
• Goldman Sachs Announces Up to US $5 Billion Settlement With Regulators for Its Handling of Residential Mortgage-Backed Securities; and more.

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Briefly:

• Non-US Broker Fined by CFTC for Soliciting Futures Orders and Handling Funds for Two US Customers Without Registration or an Exemption: Otkritie Capital International, Ltd., a UK-based broker, agreed to settle charges with the Commodity Futures Trading Commission that it solicited and accepted orders and funds from two US persons from June 2010 to October 2013 without being registered with the CFTC as a futures commission merchant or exempt from registration. According to the CFTC, Otkritie facilitated the trading of two US-based affiliates of institutional global proprietary trading organizations that were automated, algorithmic traders. After endeavoring to process an application for exemption from FCM registration with the Financial Services Authority during 2011 and 2012 (to ultimately be passed on to the CFTC) –which was rejected–, Otkritie learned in September 2013 that it was handling the two US-based customers and self-reported itself to the Financial Conduct Authority (the successor to the FSA) and the CFTC. The broker ceased handling the customers’ business the following month. Otkritie agreed to pay a fine of US $140,000 to resolve the CFTC charges.

Compliance Weeds: Ordinarily, all entities that solicit orders from US persons or handle funds in connection with futures and options must be registered with the Commodity Futures Trading Commission in some capacity (typically as a futures commission merchant or commodity pool operator if they handle funds, or in those capacities, or as an  introducing broker or commodity trading advisor if they handle orders). Part 30 of the CFTC’s rules provides a number of exemptions for non-US based entities to deal with US persons in connection with foreign futures and options contracts. One exemption – under CFTC Rule 30.5 – applies to any entity other than one that might otherwise be required to register as an FCM, while another – under CFTC rule 30.10 – applies to an entity that would otherwise be required to register as an FCM. A Rule 30.10 exemption typically requires the involvement of a local regulator as part of the exemption request process. (Click here for copies of the relevant regulations, and here for a CFTC-provided summary of applicable requirements.) Another CFTC rule authorizes certain entities outside the United States exempted from registration as an FCM under CFTC Rule 30.10 to execute US futures and options for certain institutional customers to be carried at a registered FCM subject to strict conditions. (Click here to access CFTC Rule 3.10(c)(4).)

• Broker-Dealer Fined US $15 Million for Short Sales Deficiencies: Goldman, Sachs & Co. agreed to pay a fine of US $15 million to the Securities and Exchange Commission to resolve charges that it failed to comply with certain of its obligations under so-called “Reg SHO” – the SEC’s regulation governing the short sales of equity securities. Under Reg SHO, a broker-dealer accepting a short sale of an equity security from a customer (or engaging in a short sale in its own proprietary account) must first borrow the security, enter into a bona fide arrangement to borrow the security or have reasonable grounds to believe the security can be borrowed before the delivery date. These steps are referred to as the broker-dealer’s “locate requirement.” According to the SEC, between November 2008 and mid-2013, GSCO used an automated system to handle the “vast majority” of its customers’ short sale locate requests. This system would either grant, in whole or part, deny, or send the requests to a group of individuals – known as the “Demand Team” – for further consideration. The automated system was populated each morning with available inventory based on feeds from certain lending banks and brokerages that was haircut to be conservative, and was reduced each time shares were used to grant a locate request. Over time, an increasing number of locate requests were referred by the automated system to the Demand Team and the Demand Team routinely processed the requests by using an application that solely considered each day’s beginning day share inventory, rather than the inventory reduced by prior intra-day locates. As a result, the SEC charged GSCO with executing certain short sales “without reasonable grounds to believe that the securities to be sold short could be borrowed to meet its delivery obligations.” The SEC also alleged that, when its Office of Compliance Inspections and Examinations reviewed GSCO’s lending practices in 2013, the firm “created the incorrect impression that the Demand Team conducted an individualized review for all locate requests” when it did not. The SEC acknowledged GSCO’s effort to replace its deficient automated system beginning in at least mid-2013.
   
• Industry Groups Seek to Help Court Hearing the CFTC Enforcement Action Against DRW Regarding What Constitutes Attempted Manipulation: Last week, five industry organizations asked a federal court for permission to weigh in on what are the appropriate legal standards the Commodity Futures Trading Commission must prove in a pending lawsuit against Donald Wilson and DRW Investments, LLC alleging attempted manipulation. The CFTC initially filed its lawsuit in 2013, claiming the defendants manipulated and attempted to manipulate the settlement prices of the IDEX USD Three-Month Interest Rate Swap Futures contract on numerous occasions in 2011. (Click here for a copy of the CFTC’s complaint.) Respondents generally denied the CFTC’s allegations. (Click here for a copy of respondents’ answer.) In November 2015, the CFTC moved for partial summary judgment on its attempted manipulation allegation based on, among other matters, purported “undisputed material facts” that the defendants, through their conduct, evidenced “an intent to affect price.” The five industry organizations – CME Group, Commodity Markets Council, Futures Industry Association, Intercontinental Exchange and Managed Futures Association – requested the court’s permission to file legal papers as amici curiae – a “friend of the court”— claiming the CFTC misconstrued the correct legal standard of attempted manipulation. According to the five organizations, the CFTC should be required to prove – consistent with prior case law – that respondents intended to create an artificial price – one “that does not reflect the legitimate forces of supply and demand” — not solely to affect price. Quoting from a 1982 landmark CFTC decision – In re Indiana Farm Bureau Coop Ass’n. Inc. – respondents argued this standard was appropriate because “market participants have a right to trade in their own best interests without regard to the positions of others as long as their trading activity does not have as its purpose the creation of ‘artificial’ or ‘distorted’ prices.” The five organizations said that “[c]ontinued application of this traditional standard will facilitate the promotion of price discovery and the other congressionally endorsed public interests the futures markets serve.” According to the five organizations, the CFTC has not consented to their filing of a brief as amicus curiae. (Click here to access a copy of the decision in Indiana Farm Bureau.)

Legal Weeds: On its own website, the Commodity Futures Trading Commission defines manipulation as “[a]ny planned operation, transaction, or practice that causes or maintains an artificial price” (emphasis added). (Click here to access CFTC definitions on its website.) As the CFTC recently acknowledged in adopting its new anti-manipulation and anti-fraud rules, one of the cornerstones for proving manipulation or attempted manipulation is “that the accused specifically intended to create or effect a price or price trend that does not reflect legitimate forces of supply and demand” to wit, an artificial price. (Click here to access CFTC Fact Sheet related to its anti-manipulation and anti-fraud rules, Rule 180.1 and 180.2.)  Setting aside the long established case law as capsulized in the decisions cited in the five organizations’ proposed amici curiae brief, it seems very surprising the CFTC would argue that an attempted manipulation could be an attempt to cause anything less than an artificial price in light of the CFTC’s own published plain words.

• Et Tu, SEC? – SEC OCIE Announces 2016 Examination Priorities: Two weeks ago it was the Financial Industry Regulatory Authority, last week it was the Securities and Exchange Commission. The SEC’s Office of Compliance Inspections and Examinations issued its examination priorities for 2016. As in prior years, OCIE indicated that its emphasis will revolve around three “thematic areas:” matters important to retail investors, market-wide risks and registrants engaging in illegal conduct. In looking at matters important to retail investors, OCIE said it will examine, among other things, various issues related to exchange-traded funds, including trading practices; disclosure; unit creation and redemption processes; and excessive portfolio concentration. OCIE will also look at fee arrangements at broker-dealers and investment advisers – assessing whether such arrangements are in the best interest of the relevant customers. In connection with market-wide risks, OCIE said it would review broker-dealers’ and investment advisers’ cybersecurity compliance and controls and look at liquidity controls at mutual funds, ETFs and private funds that have exposure to potentially illiquid fixed income securities. Finally, as part of its review of registrants, OCIE will review clearing and introducing brokers’ AML programs – focusing on firms “that have not filed the number of suspicious activity reports that would be consistent with their business models” as well as firms and employees that “appear to have engaged in excessive or potentially inappropriate trading.” (Click here to review FINRA’s 2016 examination priorities in the article, “FINRA Will Grade Members on Culture, Supervision and Liquidity Management; BDs Not Managing Spoofing Likely to Get Bad Scores” in the January 10, 2016 edition of Bridging the Week.)

Compliance Weeds: It is not new that the Securities and Exchange Commission is checking registrants  cybersecurity programs. Last year, OCIE announced it was conducing cybersecurity exams of SEC registrants to assess, among other things, the effectiveness of registrants’ cybersecurity controls. It said it would focus on registrants’ governance and risk assessment; access rights and controls; data loss prevention; vendor management; training; and incident response. (Click here for details in the article, “SEC Discloses Elements of Cybersecurity Exams” in the September 20,2015 edition of Bridging the Week.) Effective March 1, 2016, members of the National Futures Association must also formally adopt and begin enforcing written policies regarding cybersecurity. (Click here for details in the article “NFA Proposes Cybersecurity Guidance” in the September 13, 2015 edition of Bridging the Week.) Both SEC and CFTC registrants – big and small – should ensure they have or are promptly adopting written policies addressing cybersecurity that are appropriate to their business model and that they adhere to their policies.

• Basel Banking Committee Issues Revised Framework for Risk Capital Requirements: The Basel Committee on Banking Supervision issued a revised capital framework to purportedly better account for market risk by banks. In doing so, the Committee proposed changes to the requirements for internal models that might be utilized by banks to calculate risk, as well as changes to a standardized model that is used by default by banks not using internal models. Among other things, internal models would be required to utilize a new measure of risk – Expected Shortfall – instead of the traditional Value at Risk and stressed Value at Risk models. Expected Shortfall, according to BCBS, “measures the riskiness of a position by considering both the size and the likelihood of losses above a certain confidence level” – better capturing tail risks (i.e., extraordinarily unlikely risks) that BCBS argues are not adequately captured in current VaR measures. In addition, the new framework provides for a more “granular” internal model review process, requires approval “down to the level of the regulatory trading desk,” and limits the capital-reducing impact of hedging and diversification. BCBS estimates that, overall, its new framework will cause the amount of bank’s risk weighted assets attributed to market risk to increase to 10 percent from 6 percent. According to a statement issued by the International Swaps and Derivatives Association, Inc. and two other industry organizations, “Overall, we are concerned that despite the BCBS’s reiteration not to significantly increase overall capital requirements, trading book capital will increase by 40 percent under the new rules based on the BCBS’s impact assessment. We worry that the rules may have a negative effect on banks’ capital markets activities and reduce market liquidity.” (Click here to access ISDA’s statement.)
   
• Goldman Sachs Announces Up to US $5 Billion Settlement With Regulators for Its Handling of Residential Mortgage-Backed Securities: Goldman Sachs Group announced it had resolved “ongoing investigations” of multiple government authorities related to the firm’s securitization, underwriting and sale of residential mortgage-backed securities from 2005 to 2007 by potential payments of up to approximately US $5 billion. According to a press release issued by the firm, Goldman Sachs indicated that, under the terms of a tentative agreement, it would pay a civil fine of US $2.385 billion, make cash payments of US $875 million and provide various consumer relief, including principal forgiveness for underwater homeowners and distressed borrowers,” of US $1.8 billion. Goldman Sachs said its agreement would resolve pending and actual civil claims by the US Department of Justice, the New York and Illinois Attorneys General, the National Credit Union Administration and the Federal Home Loan Banks of Chicago and Seattle. The firm indicated that no definitive documentation has been finalized and “there can be no assurance” that any agreement will be finalized. (Click here to access my review of the recent film, The Big Short – about the collapse of the RMBS market beginning in 2007 – in the January 2, 2016 edition of Bridging the Week.)

And more briefly:

• CFTC Commissioner Bowen Says Position Limits Coming This Year: In a speech last week before the District of Columbia Bar Association, Sharon Bowen, Commissioner of the Commodity Futures Trading Commission, said she expects the CFTC’s proposed position limit rules to be finalized this year. Prior to this happening, Ms. Bowen expects the Commission soon will consider a supplemental rule proposal that will address anticipatory hedging and risk management, and provide a role for exchanges “to work with commercial participants to manage their anticipated commercial risks.”
   
• NFA Reminds Members to Know Their Exempt CTAs and CPOs and Take Reasonable Steps to Ensure a Claim of Exemption Is Bona Fide: The National Futures Association reminded members they are prohibited from dealing with persons required to be registered with the Commodity Futures Trading Commission and a member of the NFA who are not. To better comply with this obligation, the NFA also issued guidance to members regarding how they might ensure they are not violating this requirement when they deal with commodity pool operators and commodity trading advisors who are validly exempt or excluded from registration. Ordinarily, information on validly exempted or excluded CPOs and CTAs can be found on NFA’s website; however, because exempted or excluded from registration CPOs and CTAs have 60 days from year-end to mandatorily file renewed notices of their status, such evidence may be difficult to obtain through February 29, 2016.
   
• CFTC Technology Advisory Committee Meeting January 26 to Address Regulation AT and Blockchain: The Commodity Futures Trading Commission will host a meeting of its Technology Advisory Committee on January 26. Topics to be discussed included the Commission’s proposed Regulation AT, swap data standardization and harmonization, and the blockchain. (Click here for an overview of Reg AT in the article, “CFTC’s Proposed New Algorithmic Trading Rules Augur Potential Increased Obligations and Costs, and a New Registration Requirement” in the November 29, 2015 edition of Between Bridges.)
   
• Eurex Reminds Trading Participants to Use Market Data in Accordance With Their Agreements — or Else: Deutsche Borse Group reminded trading participants of Eurex Deutschland and Eurex Zurich that they may only use trading data in accordance with the general terms and conditions of their connection agreements. According to DBG, dissemination of data by an order routing system or other infrastructure to third parties or even internal recipients that are not registered traders, registered back office staff or registered applications must be notified to DBG and may require an additional license. DBG said it will take “appropriate action” if there are violations.
   
• NFA to Amend Customer Funds Protection Rules to Conform to CFTC Requirements: The National Futures Association proposed to amend certain of its rules and an interpretive notice dealing with the handling of segregated funds accounts by future commission merchants to conform its requirements to those adopted by the Commodity Futures Trading Commission in 2013. (Click here for a summary of such requirements in the article, “CFTC Adopts More Stringent Customer Funds’ Protection Rules” in the October 30, 2013 edition of what is now known as Between Bridges.) The NFA amendments generally deal with reporting obligations by FCMs.
   
• Another Day, Still More Enhancements to CPO Form PQR by NFA: The National Futures Association announced further changes to Form PQR for commodity pool operators. These “slight enhancements” are effective for the quarter ending December 2015. CPOs are required to file Form PQR each quarter to provide NFA information about their operations and the operations of pools they operate. The NFA recently published guidance in the form of frequently asked questions related to CPO Form PQR and commodity trading advisors Form PR. (Click here for further information in the article, “NFA Augments CFTC’s FAQs Regarding CPO Form PQR and CTA Form PR” in the November 15, 2015 edition of Bridging the Week.)

And finally:

Totally Irrelevant (But Is It?): Billions: Ambiguity in Control: The January 17, 2016 inaugural episode of Billions, the new Showtime serial drama revolving around the interactions of a fictional US Attorney in New York –Chuck Rhoades (played by Paul Giamatti)– and a highly successful hedge fund manager located in Westport, Connecticut –Bobby “Axe” Axelrod (performed by Damian Lewis) — centered on the theme of domination. From the opening scene (and last one too), where Mr. Rhoades’ wife (played by Maggie Siff) exerts S&M control over her husband, Billions offers multiple occasions where both Mr. Rhoades and Mr. Axelrod each scheme to manipulate the universe of people and events around them to achieve desired outcomes, leaving little to chance.  Indeed, there is even the suggestion that both individuals’ great success in their respective careers might be attributable more to their testosterone-driven efforts at control than solely talent. Future episodes will likely confirm whether Mr. Axelrod’s trading success is attributable to uncanny analysis or the receipt of illegal insider information, and whether Mr. Rhoades perfect record in prosecuting financial crimes is the result of extraordinary legal work, or pursing just easy cases. But nothing will be clear-cut.  Mr. Axelrod my be a megalomaniac, but he seems generous in trying to help the owner of a pizzeria he has patronized since childhood survive when the neighborhood shop is threatened by escalating rents. He also seems magnanimous in awarding children of former employees killed on 9-11 scholarships to college. Likewise, Mr. Rhoades may appear to have a holier than thou approach to prosecution and to be an out-of-control bully when dealing with a fellow regulator from the Securities and Exchange Commission, but his heartfelt soliloquy about the inequality in the way different types of convicted criminals are sentenced seems sincere. This introduction and amplification of ambiguity seems to be a main goal of Billions – to suggest that in the arena of potential white collar crime, it is not clear who the good guys and bad guys are. Just like in a classic Greek drama, there is the forecast that one, if not both, of the lead characters ultimately will fall —in the very not-classic Greek drama side story involving the neutering of Mr. Axelrod’s German Shepherd. There is also the suggestion that Mr. Rhoades’ wife –who seems to greatly enjoy her conflicting roles, playing both dominatrix to her husband, as well as personal cheerleader to Mr. Axe in her capacity as staff psychiatrist at Mr. Axe’s hedge fund— is likewise a power-hungry personality likely to sustain some humiliating defeat in the future.  But, so far there has been only one episode of Billions and simply intimations of possible outcomes. More fun, for sure, seems to be in store going forward. Billions, created by Brian Koppelman, David Levien and Andrew Ross Sorkin is scheduled to air on Showtime on Sunday evenings at 10 pm ET. (Click here for a preview of Billions.)

For more information, see:

Another Day, Still More Enhancements to CPO Form PQR by NFA:
https://www.nfa.futures.org/news/newsNotice.asp?ArticleID=4679

Revised Framework for Risk Capital Requirements:
http://www.bis.org/bcbs/publ/d352.htm

Broker-Dealer Fined US $15 Million for Short Sales Deficiencies:
http://www.sec.gov/litigation/admin/2016/34-76899.pdf

CFTC Commissioner Bowen Says Position Limits Coming This Year:
http://www.cftc.gov/PressRoom/SpeechesTestimony/opabowen-7

CFTC Technology Advisory Committee Meeting January 26 to Address Regulation AT and Blockchain:
http://www.cftc.gov/idc/groups/public/@lrfederalregister/documents/file/2016-297a.pdf

Eurex Reminds Trading Participants to Use Market Data in Accordance With Their Agreements — or Else:
https://www.eurexchange.com/exchange-en/resources/circulars/Reminder--Compliance-with-rules-governing-the-usage-of-market-data/2347660

Et Tu, SEC? – SEC OCIE Announces 2016 Examination Priorities:
http://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2016.pdf

Goldman Sachs Announces Up to US $5 Billion Settlement With Regulators for Its Handling of Residential Mortgage-Backed Securities:
http://www.goldmansachs.com/media-relations/press-releases/current/announcement-14-jan-2016.html

Industry Groups Seek to Help Court Hearing the CFTC Enforcement Action Against DRW Regarding What Constitutes Attempted Manipulation:
/ckfinder/userfiles/files/FIA%20DRW%20Amicus.pdf

NFA Reminds Members to Know Their Exempt CTAs and CPOs and Take Reasonable Steps to Ensure a Claim of Exemption Is Bona Fide:
https://www.nfa.futures.org/news/newsNotice.asp?ArticleID=4681

NFA to Amend Customer Funds Protection Rules to Conform to CFTC Requirements:
http://www.nfa.futures.org/news/PDF/CFTC/FR_Sec_1_Sec_16_IntNotc_Protections_CustomerFunds_FCM_DCO_Rulemaking.pdf

Non-US Broker Fined by CFTC for Soliciting Futures Orders and Handling Funds for Two US Customers Without Registration or an Exemption:
http://www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfotkritieorder11316.pdf

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of January 16, 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.