The Commodity Futures Trading Commission proposed new rules addressing cross-border swap transactions. In response, Chairman Heath Tarbert invoked the German philosopher Immanuel Kant to support the CFTC’s proposal while Commissioner Dan Berkovitz relied on the comedic philosopher Jerry Seinfeld to help frame his opposition. Separately, the Securities and Exchange Commission brought and settled an enforcement action against a company that sold digital tokens to raise funds for the development of a bitcoin blockchain-encoded integration platform to enhance the security and ease of use of the distributed ledger system. Although no fraud or deception was alleged, the SEC considered the sale an illegal securities offering. As a result, the following matters are covered in this week’s edition of Bridging the Week:
This is the last regularly scheduled edition of Bridging the Week for 2019. The next scheduled edition of Bridging the Week is January 14, 2020.
The CFTC also issued final rules amending certain requirements of derivatives clearing organizations related to governance, risk management, reporting and other matters, and proposed rules prohibiting post-trade name give-up practices for swaps that are meant to be cleared and are anonymously executed in the first instance on swap execution facilities.
Three divisions of the CFTC additionally issued relief to swap dealers and other market participants to assist in an industry migration from swaps that rely on the London Interbank Offered Rate and other interbank offered rates to swaps that reference alternative benchmarks.
The CFTC’s proposed cross-border rules principally clarify when a person’s cross-border swaps or swap positions implicate swap dealer registration requirements. The proposed rules also introduce a substituted compliance regime from certain CFTC regulations for non-US swap dealers that “emphasizes a holistic, outcomes-based approach that is grounded in principles of international comity.” The CFTC said its proposal leverages the adoption of comprehensive swaps regulation in many jurisdictions since July 2010 outside the United States, and reflects concerns about market fragmentation that arise when there are conflicting and duplicative requirements between US and non-US regulators.
Among other things, the CFTC proposed that the definition of US person should be based solely on the US physical presence or legal organization of a person. For collective investment vehicles, however, the territorial analysis should apply to the geographic location of the office from which the manager primarily directs, controls and coordinates the fund; the fact that a CIV is majority owned by one or more US persons should not trigger it being designated a US person on its own.
As proposed, a US person would have to include all dealing swaps in its de minimis threshold calculation (i.e., US $8 billion of gross notional value dealing swaps on a rolling one-year basis) to determine whether it must register as a swap dealer. Only non-US persons that are formally guaranteed by US persons (“guaranteed entities”) and significant risk subsidiaries would have to count all their dealing swaps against the de minimis threshold and potentially register as swaps dealers. (An SRS would be a newly defined entity and constitute non-US persons that are part of a holding company organization with an ultimate parent entity with US $50 billion or more of global consolidated assets and not subject to consolidated supervision and regulation by the Board of Governors of the Federal Reserve System or capital standards and oversight by the non-US person's home country regulator that are consistent with international standards for banks.)
Other non-US persons would have to count dealing swaps with US persons and guaranteed entities against the de minimis threshold, except for swaps with a foreign branch of a registered swap dealer or a guaranteed entity that is registered as a swap dealer. Swaps against an SRS would not have to be counted.
The CFTC also proposed that non-US swap dealers that arranged, negotiated or executed swaps from the US (“ANE Transactions”) would not have to comply with CFTC swap dealer transaction-level requirements in connection with their swaps with non-US persons. Generally, said the CFTC, such swap transactions would already be subject to regulation and oversight “similar to the Commission’s transaction-level requirements” in the non-US persons’ home countries. Moreover, non-US swap dealers engaging in ANE transactions would have their ANE activities subject to CFTC anti-fraud and anti-manipulative conduct prohibitions, argued the Commission. (Click here to access 7 U.S.C. § 9(1) and here for CFTC Rule 180.1.)
The CFTC based its proposal rules on its reading of relevant law (click here to access 7 U.S.C. § 2(i)) that applies swaps provisions to non-US activities that either have a “direct and significant effect on U.S. commerce” or “a direct and significant connection with activities in U.S. commerce, and through such connection present the type of risks to the U.S. financial system and markets that [Dodd-Frank] directed the Commission to address.” As a result, the CFTC determined to interpret the term “direct” to require “a reasonably proximate causal nexus” and not “foreseeability, substantiality, or immediacy.” Also, in light of the evolution of global swaps regulation, the CFTC determined to apply principles of international comity to minimize conflicts with other countries’ laws.
In supporting the Commission’s reliance on other countries’ regulatory regimes in connection with the oversight of cross-border swaps activity, CFTC Chairman Heath Tarbert invoked Immanuel Kant’s concept of the “categorical imperative.” He said it “would be absurdity” if the CFTC imposed its requirements on non-US persons whenever the swaps transactions had a “remote nexus to the United States.” This, he said, would lead to every regulator trying to oversee everyone else. As a result, he argued, “[w]e should not impose our regulations on the non-U.S. activities of non-U.S. companies in those jurisdictions that have comparable capital and margin requirements as our own.”
Commissioner Dan Berkovitz expressed a different perspective, decrying what he claimed was the creation of “multiple loopholes for U.S. banks to evade the Commission’s oversight of their cross-border activity [that would] pose risk to the U.S. financial system.” Among other things, he said that the proposed application of US swap dealer requirements to the newly created SRS entities would apply to few, if any firms. As a result, he claimed “[t]his is a Seinfeldian regulation – a regulation about nothing.” He also objected that the CFTC’s proposed approach regarding ANE transactions would authorize US persons “to undertake substantial dealing activity in the United States and then evade regulation by booking the trades in foreign entities.”
The CFTC will accept comments on its proposed cross-border swap dealing rules for 60 days following their publication in the Federal Register.
The SEC’s final rules on cross-border activity dealt with cross-border activity involving security-based swaps, including single name credit default swaps. They will be effective the later of March 1, 2020 or 60 days after their publication in the Federal Register.
Derivatives Clearing Organizations
The CFTC’s final DCO rules amendments deal with governance, as well as certain risk management and reporting obligations and other matters. Among other things, they address DCOs' obligations regarding written acknowledgments pertaining to the segregation of customer funds; procedures for registration and implementing rules and clearing new products; compliance with core principles; financial resources; participant and product eligibility; risk management; default rules and procedures; reporting; and fully collateralized positions.
DCOs must comply with all new CFTC requirements by one year after the date of publication of the final rules in the Federal Register. The CFTC proposed amendments to its DCO rules in May 2019 (click here to access the relevant Federal Register release).
Post-Trade Name Give-Up and LIBOR Transition
The CFTC also proposed to ban post-trade name give-up practices for intended-to-be cleared swaps executed anonymously on swap execution facilities. The revised rule would prohibit a SEF from directly or indirectly disclosing the identity of relevant counterparties – including through a third-party service provider. Moreover, the revised rule would require SEFs to enact and enforce rules to preclude persons from causing such a disclosure.
Comments on this proposal will be accepted by the CFTC for 60 days following its publication in the Federal Register.
Separately, the Divisions of Swap Dealer and Intermediary Oversight, Market Oversight and Clearing and Risk published no-action letters to help swap dealers and other industry participants migrate from uncleared swaps that reference LIBOR or other interbank benchmarks to swaps that reference alternative benchmarks such as the secured overnight financing rate.
Memory Lane: In September 2014, a US federal court mostly tossed out all legal challenges brought by three industry groups to the CFTC’s first attempt post-adoption of the Dodd-Frank Wall Street Reform and Consumer Protection Act to address swap dealer registration and other related issues emanating from cross-border activities in its 2013 Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations. (Click here for background on the CFTC’s Interpretive Guidance in the article “CFTC Enacts Interpretive Guidance and Passes Exemptive Order regarding Cross Border Swaps Transactions” in the July 16, 2013 edition of Between Bridges.)
In ruling generally against the plaintiffs, the court adopted the CFTC’s principal argument, that Dodd-Frank’s swaps requirements applied extraterritorially when swaps activity outside the United States had a “direct and significant connection” with US commerce without the need for any implementing regulations. As a result, the court said, “[t]he CFTC was not required to issue any guidance (let alone binding rule) regarding its intended enforcement policies. … Indeed, the CFTC’s decision to provide such a non-binding policy statement benefits market participants and cannot now, all other things being equal, be turned against it.”
Notwithstanding, the court ordered the CFTC to conduct a cost-benefit analysis regarding the extraterritorial application of many of the CFTC’s rules addressed in the cross-border guidance. (Click here for further details regarding the court’s ruling in the article “Federal Court Tosses Out Challenges to CFTC Cross-Border Guidance and Policy Statement” in the September 16, 2014 edition of Between Bridges.)
In response, the CFTC sought comment on its cross-border guidance in March 2015. (Click here for details in the article “CFTC Formally Responds to Court Judgment on International Guidance; Calls for Public Comments” in the March 15, 2015 edition of Bridging the Week.)
The CFTC incorporated responses to its 2015 solicitation in a 2016 cross-border rules proposal that is now withdrawn and replaced by the CFTC’s current proposal. (Click here for details regarding the CFTC’s earlier proposal in the article “CFTC Requires All Non-US Consolidated Subsidiaries of US Parents to Count All Swaps in De Minimis Threshold in Proposed Cross-Border Rules” in the October 16, 2016 edition of Bridging the Week.)
"Yet, even at first glance, derivatives regulation and Kant’s philosophy share some strikingly common attributes Title 17 of the Code of Federal Regulation [containing all CFTC rules] and The Critique of Pure Reason… (1781) are impenetrable to all but a handful of subject matter experts. And scholars spend decades writing and thinking about them, often coming up with more questions than answers."
Sadly, I still remember back in 1982 when I began my practice of derivatives law, the infamous “white book” that contained the Commodity Exchange Act and all CFTC regulations was less than an inch or so thick. Now the white book is no longer white and it is approximately six inches thick. Simpler times seem “a long time ago in a galaxy far, far away."
This article was amended on December 23 to more precisely describe topics addressed in the CFTC's final DCO rule.
ICO Issuer Sanctioned US $250,000 by SEC and Required to Offer Refund of Investment to Initial Purchasers: The Blockchain of Things agreed to resolve charges brought by the Securities and Exchange Commission that its sale of digital assets from December 2017 through December 2018 – labeled as a pre-sale and initial coin offering (collectively, the “ICO”) – constituted an illegal offering of securities that were neither registered nor lawfully exempt.
To resolve the SEC’s allegations, BCOT agreed to pay a fine of US $250,000; register its digital tokens as securities; offer refunds to all persons who purchased BCOT digital tokens during the ICO; and refund relevant amounts to all qualified persons who request payment.
According to the SEC, BCOT sought to raise funds through its ICO to help further develop a bitcoin blockchain-encoded platform – the Catenis platform – to enhance the blockchain's security and ease of use. At the time of its ICO, BCOT claimed that its Catenis Enterprise technology was a “live network (in beta) with several active corporate clients”; however, at the time of the ICO, claimed the SEC, “there was no ‘ecosystem’ of third party applications developed” for the platform. The SEC said that BCOT contracted with four resellers in Asia and the Middle East to sell its digital tokens in their geographic regions; however, it did not preclude the resellers from dealing with US purchasers. (Clock here to access the BCOT white paper.)
The SEC argued that purchasers of BCOT tokens “would have reasonably viewed the [ICO] as an opportunity to profit if BCOT were successful in its entrepreneurial and managerial efforts to develop its business and ecosystem.” As a result, the ICO constituted the illicit sale of an investment contract, contrary to guidance previously issued by the SEC in its July 2017 “The DAO” 21A Order. (Click here for background in the article “SEC Declines to Prosecute Issuer of Digital Tokens That It Deems Securities Not Issued in Accordance with US Securities Laws” in the July 26, 2017 edition of Between Bridges.)
The SEC claimed that BCOT raised US $13 million from investors in the United States and Asia. The Commission did not allege that BCOT committed any fraudulent acts or deception in connection with its offering. The SEC acknowledged BCOT’s remedial acts and cooperation in accepting its offer of settlement.
In its enforcement action against AirFox, the SEC alleged that the company issued digital tokens – termed “AirTokens” – to raise funds to develop a “new, international business and ecosystem” that would permit holders to transfer AirTokens to each other, engage in peer-to-peer lending, and to buy and sell goods and services, as well as take advantage of existing company functionality.
In its enforcement proceeding against Paragon, the SEC claimed that the company initiated an ICO to raise funds to bring blockchain technology to the cannabis industry and promote the legalization of cannabis.
Both companies promoted their ICOs as an opportunity to profit through appreciation in the price of their tokens, said the SEC. Neither AirFox’s nor Paragon’s blockchain-based business models were up and running at the time of their ICOs, which were marketed, noted the SEC, to the general public. Each company said they would take steps to list their tokens on secondary markets.
To settle allegations by the SEC, both AirFox and Paragon also agreed to pay fines of US $250,000 and to offer to refund and to remit to requesting investors the full amount of their investments in the relevant ICO.
(Click here for further details in the article “SEC Assesses Penalties for Non-Fraudulent Initial Coin Offerings and Requires Registration; Issues Advisory on Issuance and Trading of Cryptosecurities” in the November 18, 2018 edition of Bridging the Week.)
More recently, Block.one, a technology corporation and developer of the EOSIO software, settled allegations brought by the SEC that it engaged in an unlawful securities offering to US persons when it conducted an ICO between June 2017 and June 2018. The SEC claimed that, during the relevant time, the company offered and sole 900 million ERC-20 EOS digital tokens in exchange for ether valued in excess of “several billion dollars.” To resolve the SEC’s charges, Block.one agreed to pay a fine of US $24 million but was not required to offer any refunds to investors in its ICO. (Click here for background in the article “Blockchain Technology Company Agrees to Pay US $24 Million to Resolve SEC Allegations of an Unlawful Initial Coin Offering” in the October 6, 2019 edition of Bridging the Week.)
Earlier this year, the SEC’s Strategic Hub for Innovation and Financial Technology issued guidance on what characteristics a cryptoasset might have that could make it more likely to be deemed an investment contract, and thus a security, under US securities laws. FinHub noted that these characteristics pertain not solely to the “form and terms” of the digital asset itself, but also “the means in which it is offered, sold or resold (which includes secondary market sales).” (Click here for background in the article “SEC Staff Outlines Characteristics of Cryptoassets That Could Cause Them to Be Regarded as Securities” in the April 7, 2019 edition of Bridging the Week.)
Initially, natural persons holding a Series 7 (general securities representative), 65 (investment advisor representative) or 82 (private securities offerings representative) license or other credentials from an accredited educational institution would additionally qualify as an accredited person under the SEC’s amendments, as would designated “knowledgeable employees” of a private fund regarding investments in the fund. Newly-designated accredited investors would also initially include limited liability companies that meet certain conditions as well as registered investment companies and rural business investment companies. Family offices holding at least US $5 million in assets would also qualify as accredited investors as proposed.
In its proposal, the SEC solicited comments suggesting it might also consider even a more expansive expansion of accredited investor to include any natural person advised by a registered investment advisor.
In adopting its proposal, the SEC acknowledged that adopting “an overly broad definition [of accredited investor] could potentially undermine important investor protections and reduce public confidence in this vital [private securities] market.” However, the SEC also expressed concern that maintaining a narrow definition precludes participation in investment opportunities by persons “where there may be adequate investor protection given factors such as that investor’s financial sophistication, net worth, knowledge and experience in financial matters, or amount of assets under management.”
Qualified companies are authorized to sell new securities in the United States under various exemptions to securities registration requirements included in the SEC’s Regulation D, provided such sales are either principally or exclusively sold to accredited investors (depending on the exemption. Click here for background on Sections 506(b) and 506(c) of SEC Regulation D.)
The SEC also proposed amendments to expand its definition of “qualified institutional buyers,” to enable more types of non-natural persons to purchase certain restricted, unregistered or control securities pursuant to another exemption from SEC registration requirements. (Click here to access background regarding SEC Rule 144A.)
The SEC’s proposals follow its publication of a concept released on the same topics earlier this year. (Click here for background in the article “SEC Seeks Comments on Private Offering Harmonization Initiative” in the June 23, 2019 edition of Bridging the Week.)
Comments on the SEC’s proposals will be accepted for 60 days following their publication in the Federal Register.
My View: In a separate statement, SEC Commissioner Robert Jackson expressed concern that the SEC’s proposal “does not take seriously the investor protection concerns present in private markets.” (Click here to access Commissioner Jackson's full statement.) However, this concern elevates the SEC’s current emphasis on financial ability as the touchstone of who may purchase private securities over demonstrable possession of financial markets acumen. However, where there is less disclosure – such as in private securities offerings as opposed to registered offerings – possessing financial markets knowledge, not wealth, is likely more important. The SEC’s proposals recognize this and hopefully, in at least substantial form, will be adopted.
Approximately two months ago, Lek Securities and Mr. Lek settled charges brought by the SEC that they facilitated manipulation by a client, Avalon FA Ltd, a non-US entity, and two of its control persons. The SEC claimed that Avalon engaged in spoofing trading involving stocks “in hundreds of thousands of instances” between approximately December 2010 through at least September 2016 and cross-market manipulation from at least August 2012 through at least December 2015.
The SEC claimed that Lek Securities and Mr. Lek helped Avalon engage in its purportedly illicit conduct by providing the non-US firm access to US markets, relaxing Lek Securities’ layering controls after Avalon objected, and improving Lek Securities’ technology to help Avalon’s trading. To resolve the SEC’s complaint, Lek Securities agreed to pay a fine of US $1 million and US $525,892 in disgorgement and prejudgment interest and Mr. Lek consented to remit a US $420,000 fine. Lek Securities also agreed not to provide intraday-trading access to foreign customers except under limited prescribed circumstances, and to retain a compliance monitor for three years.
FINRA’s and the exchanges’ allegations against Mr. Lek and Lek Securities echoed the SEC’s charges. FINRA and the exchanges claimed that notwithstanding their and the SEC’s longstanding investigation, the respondents permitted Avalon’s problematic trading to go on for a substantial period of time.
Under the SEC’s market access rule, broker-dealers, like Lek Securities, are obligated to reasonably control the financial and regulatory risk of access to exchanges or other markets by their customers who are provided market access.
(Click here for background on the SEC’s market access rule. Click here for background on the SEC’s enforcement action and settlement against Mr. Lek and Lek Securities in the article “Broker-Dealer and CEO Agree to Almost US $2 Million Penalty With SEC for Facilitating Alleged Manipulative Trading by Non-US-Based Trading Firm” in the October 13, 2019 edition of Bridging the Week.)
According to FINRA, under its rules, Robinhood was obligated to conduct an order-by-order review or a “regular and rigorous review” when it relied on third-party brokers to execute its customers’ orders in order to assess execution quality. Since it did not conduct an order-by-order review, Robinhood was obligated to review at least quarterly the quality of its customers’ executions on a security-by-security and type-of-order basis. (Click here to access FINRA Rule 5310 and related guidance.)
FINRA charged that Robinhood failed to meet its due diligence obligations because during the relevant time, it failed to consider the execution quality of its current execution venues and only considered its preexisting venues. Moreover, the firm did not conduct best execution reviews of certain types of relevant orders, including nonmarketable limit orders, stop orders, and orders received outside regulator trading hours.
To resolve FINRA’s charges, Robinhood agreed to pay a fine of US $1.25 million and to retain an independent consultant to review its compliance with FINRA best execution requirements, and adopt and implement all recommendations except under limited circumstances.
According to the CFTC, the alleged manipulative scheme occurred during June and July 2012 and was instituted in response to Mr. Rivoire’s knowledge of an impending US dollar-denominated bond issuance by the client that the client planned to hedge with an interest rate swap opposite HSBC. The CFTC said that Mr. Rivoire knew that the client intended to price its hedge basis prices posted by an unnamed inter-dealer broker firm. In response, the CFTC claimed that Mr. Rivoire engaged a trader he supervised to help him work with the inter-dealer broker to decrease the price of five-year basis swaps on the broker’s screens. This purportedly resulted in a less profitable transaction for the issuer and a transaction with more profit for HSBC.
Separately, Sunrise Brokers LLP consented to pay a fine of US $90,000 to the Commodity Exchange, Inc. to resolve allegations that, in connection with block trades from November 2017 through November 2018, it submitted inaccurate execution times and failed to report such trades within required time frames
Finally, Hongchae Chung agreed to pay a fine of US $90,000 and disgorge profits of US $19,018 to NYMEX and COMEX related to purported spoofing trades between August 2017 and March 2018. Unrelatedly, Jitender Sharma consented to be permanently barred from access to all CME Group exchanges in connection with purported spoofing on the COMEX from October 12 through October 19, 2017.
For further information:
CFTC Proposes Cross-Border Swap Dealer Rules; Chairman Cites Kant in Support and Commissioner Berkovitz References Seinfeld in Opposition:
SEC Final Rule:
COMEX and NYMEX Sanction Traders for Block Trades and Spoofing Violations:
FINRA and Exchanges Fine Broker-Dealer US $900,000 and Permanently Suspend Principal for Supervisory Failures and Violating SEC’s Market Access Rule:
Former Investment Bank Executive Charged by CFTC With Manipulating Interest Bank Swaps:
ICO Issuer Sanctioned US $250,000 by SEC and Required to Offer Refund of Investment to Initial Purchasers:
SEC Proposes to Increase Categories of Potential Investors Eligible to Purchase Privately Issued Securities:
Zero Commission Broker Fined US $1.25 Million by FINRA for Routing Equity Orders to Other Broker-Dealers Who Remitted Payments:
The information in this article is for informational purposes only and is derived from sources believed to be reliable as of December 21, 2019. 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. Views of the author may not necessarily reflect views of Katten Muchin or any of its partners or employees.