Bridging the Week by Gary DeWaal: June 24 – 28, and July 1, 2019 (Wash Sales; Another Spoofing Settlement)

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Published Date: June 30, 2019

A trading firm agreed to settle charges brought both by the Commodity Futures Trading Commission and the Chicago Board of Trade that trading activities it engaged in during pre-opening market periods constituted wash sales. The firm was apparently trying to neutralize the risk of pending orders it was not permitted to withdraw or amend by exchange rule when it saw that the indicative opening price was moving in an adverse direction. Separately, a subsidiary of a major bank agreed to pay US $36.5 million to settle charges by the Department of Justice and the CFTC related to spoofing activity. As a result, the following matters are covered in this week’s edition of Bridging the Week:

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EMM also agreed to resolve a parallel disciplinary action based on similar facts brought by the Chicago Board of Trade. To resolve the CBOT matter, EMM agreed to pay an additional fine of US $150,000.

Generally, as alleged by the CBOT, EMM entered orders in a pre-opening period to buy or sell relevant futures contracts for execution on or after the next market session’s opening. During this predetermined time, traders can enter, amend or cancel orders; however, no orders can be executed. Moreover, just prior to the expiration of the pre-opening period, there is a distinct “No-Cancel” or “Lockdown” segment (typically 30 seconds) when traders can continue to enter (but not execute) new orders, and cannot amend or cancel pending orders.

Because market conditions changed during the No-Cancel periods and caused variations in the indicative opening prices, EMM traders sometimes wanted to cancel their pending orders but were not permitted to do so. In response, alleged the CFTC and CBOT, EMM traders placed offsetting offers (sell orders) lower than their pending bids (buy orders) and offsetting bids higher than their pending offers. When the relevant markets opened, these outstanding bids and offers sometimes executed opposite each other at the same price or otherwise were offset indirectly through market activity.

The CFTC charged that these purposeful placements of buy and sell orders for the same entity that were intended to, and in fact did, offset constituted illegal wash and fictitious sales under applicable law (click here to access the Commodity Exchange Act, § 4c(a)(1) and (2), 6 U.S.C. § 6c(a)(1), (2).) and noncompetitive trades under CFTC Rule 1.38(a) (click here to access). This is because the orders were placed with the intent to take no market risk by the same legal entity and, in fact, some of the orders were offset against each other.

CBOT claimed that EMM’s conduct also violated its own prohibition against wash trades. (Click here to access CBOT Rule 534.) The key for CBOT was, as it was for the CFTC, the placement of opposite side orders by EMM traders for the same legal entity – EMM – with the intent to offset, and the actual offset of trades either directly or indirectly after market open.

Additionally CBOT alleged that EMM failed to supervise its traders who placed the relevant orders. According to CBOT, it sent warning letters regarding wash trades and restrictions on pre-opening orders to EMM traders; however, in response, EMM did not provide “adequate guidance” regarding the exchange’s requirements to its traders.

Although the CFTC could not charge EMM with failure to supervise because the firm is not currently a CFTC registrant (click here to access CFTC Regulation 166.3), it required EMM as part of its settlement to implement and enhance its internal controls and procedures to achieve compliance with its requirements regarding wash sales and noncompetitive trading, including conducting adequate training programs and implementing measures to detect and deter prohibited trading activity.

In November 2012, EMM agreed to pay a separate fine of US $220,000 to the CFTC for allegedly violating spot month position limits involving corn futures and not diligently supervising its traders. At the relevant time, EMM was registered with the CFTC as a futures commission merchant and in other capacities. (Click here to access the relevant CFTC Order.)

My View: The societal benefit of having parallel actions brought against the same respondent for the same basic offense by the CFTC and an exchange acting in its self-regulatory organization capacity is not clear, particularly here where the defendant’s challenged conduct is restricted to a single exchange. The CFTC has limited resources, and it is likely best that it restrict its enforcement activity to matters for which it has unique jurisdiction or a policy rationale to make a powerful statement. Where there is overlapping jurisdiction with an SRO, the CFTC should otherwise defer to the SRO’s handing of an enforcement matter.

Compliance Weeds1: CME Group formally states in guidance that market participants “should have a reasonable expectation” that buy orders placed during pre-open periods and priced at or above the price of a resting sell order, or sell orders priced at or below the price of a resting buy order, may match when market orders open, either directly against each other or indirectly opposite different counterparties. In either case, CME Group exchanges will regard such orders as entered with “the intent to negate or strictly limit market risk,” and, if executed as offsets, either directly or indirectly, as wash sales. (Click here to access CME Group MRAN RA 1903-5, Q/A 5. See also “Examples of Prohibited Activity During the Pre-Open Period” in the same MRAN. Click here for general background on CME Group’s wash trade prohibition.)

Compliance Weeds2: Developing an effective compliance program is not rocket science. There are a few core elements: (1) identify applicable legal and regulatory requirements; (2) implement and update relevant policies and procedures reasonably designed to ensure adherence to the identified legal and regulatory requirements; (3) monitor compliance; (4) act on all possible violations; and (5) training. None of these elements should be static because legal and regulatory requirements may change because of evolving businesses or requirements; how best to ensure compliance may change because of practical experience or technological changes; and different types of monitoring are likely for different requirements and, likewise, may change because of practical experience or technological advances. All possible violations should be addressed – either by clearing false positives or acting on actual problems. Training should occur at least annually, as well as when there are new businesses and/or requirements, or when persons may require additional knowledge. 

Effective compliance programs should vary from firm to firm as they must be adapted specifically for different business models and operations. One size does not fit all, and pie-in-the-sky, generic and outdated compliance programs will likely cause issues.

Having an effective compliance program is the bedrock of a strong compliance culture.

Compliance Weeds3: Only CFTC registrants are subject to its duty to supervise (see CFTC Regulation 166.3). However, all persons trading on CME Group exchanges or on ICE Futures U.S. are subject to a duty to supervise by exchange rule. (Click here to access CME Group MRAN RA-1620 generally describing the obligation of every party trading on the exchange to supervise all of its employees and agents, as well as their potential liability for their employees' and agents rules' violations. Click here to access IFUS Rule 4.01 regarding similar obligations and potential liability by IFUS traders. Click here to see also, for contrast, obligations of ICE Futures Europe members (not traders) to maintain an express supervisory structure in "ICE Futures Europe and ICE Endex Guidance on Member Requirements under MiFID II.")

According to the CFTC, on numerous occasions during the relevant time, the MLCI traders and affiliates they employed placed small orders on one side of a Commodity Exchange, Inc. futures market to execute a larger order or multiple orders on the opposite side of the same market with the intent to induce execution of their smaller order. As soon as the small order was filled in whole or in part, the traders would cancel the larger orders.

The CFTC charged in an enforcement proceeding that this conduct constituted traditional manipulation or attempted manipulation at all times and, after August 15, 2011, spoofing as well as fraud-based manipulation and attempted manipulation. (Click here to access post-August 2011 relevant provisions: Commodity Exchange Act § 4c(a)(5)(C), 7 U.S.C. § 6c(a)(5)(C); here for §§ 6(c)(1) and 6(c)(3) of the Act, 7 U.S.C. §§ 9(1), (3) and here for CFTC Regulations 180.1 and 180.2.) In a non-prosecution agreement with MLCI, the DOJ implied that the firm’s conduct may have touched prohibitions against wire fraud, securities and commodities fraud and spoofing. (Click here to access 18 U.S.C. § 1343 and here for 18 U.S.C. § 1348.)

In accepting MLCI’s settlement offer, the CFTC acknowledged the firm’s cooperation and remediation. The CFTC assessed a specific fine of US $11.5 million, and restitution and disgorgement totaling US $13.5 million to be offset by amounts paid for the same purpose to DOJ. MLCI agreed to pay US $25 million to the DOJ which includes a criminal fine, forfeiture and restitution.

The DOJ previously filed criminal actions against Edward Bases and John Pacilio, former precious metals traders at MLCI, for wire and commodities fraud related to spoofing in early 2018. (Click here for background in the article “CFTC Names Four Banking Organization Companies, a Trading Software Design Company and Six Individuals in Spoofing-Related Cases; the Same Six Individuals Criminally Charged Plus Two More” in the February 4, 2018 edition of Bridging the Week.)

MLCI is a subsidiary of Bank of America Corporation.

Legal Weeds: Recently, Mr. Bases and Mr. Pacilio sought to dismiss their indictments charging them with wire and commodities fraud, arguing that their alleged spoofing did not involve a material misrepresentation that “falsely and fraudulently represented to market participants that [they] were willing to trade [orders] when, in fact, they were not” as charged by the DOJ. This is because, claimed the defendants, all their open-market orders were real and genuine, as any counterparty could have accepted them, and the defendants would have performed on their executed trades. They claimed that a criminal allegation of commodities and wire fraud required them to place orders that were fake; they claimed their orders were real. (Click here for background in the article “Spoofing Is Not Fraud Argue Traders Subject to Criminal Prosecution” in the December 2, 2018 edition of Bridging the Week.)

Compliance Weeds: In September 2017, Merrill Lynch, Pierce, Fenner & Smith Incorporated agreed to pay a fine of US $2.5 million to resolve charges brought by the CFTC that, from January through October 2010, the firm failed diligently to supervise responses to a CME Group Market Regulation investigation related to block trades executed by its affiliate, Bank of America, N.A. (“BANA”) on the Chicago Mercantile Exchange and the Chicago Board of Trade. The CFTC also charged Merrill – a CFTC-registered futures commission merchant – with having inadequate procedures related to the preparation and maintenance of records related to block trades, and for failing to prepare and/or maintain records related to certain block trades, as required by Commission regulation, from at least January 2010 through June 2012.

In connection with the exchanges’ investigation, Merrill appears to have solely passed along to the exchanges information provided to it by BANA which later on was recognized to be incomplete. Later it was also recognized that BANA personnel had been impermissibly front-running a counterparty’s block trades.

Although BANA admitted to impermissibly pre-hedging block trades and agreed to material sanctions for that offense, an important fallout of Merrill's CFTC settlement order is the suggestion that registrants may have an affirmative obligation of some kind to ensure that information and analysis they obtain from accountholders is accurate prior to passing it along to regulators even when they have no notice that such information may be inaccurate. Such an expectation appears too burdensome and practically unrealistic. (Click here for further background in the article “FCM Agrees to Pay US $2.5 Million CFTC Fine for Relying on Affiliate’s Purportedly Misleading Analysis of Block Trades for a CME Group Investigation” in the September 24, 2017 edition of Bridging the Week.)

More Briefly:

Separately, the Commodity Exchange, Inc. accepted settlement offers from five individuals that allegedly failed to participate in  exchange investigations. Each individual agreed to pay a fine of US $40,000 and be denied all CME Group exchanges’ trading access for one year.

For further information

Bank Subsidiary Agrees to Pay US $36.5 Million to Resolve Department of Justice and CFTC Enforcement Actions for Spoofing:

CFTC Seeks New Rule to Terminate Cross-Border-Granted Exemptive Relief:

Custody Bank Consents to Pay $88 Million as SEC Fine and Disgorgement Because of Client Overcharges:

Exchange-Traded Swaps Excluded From Swap Dealer Calculation for Registered Floor Traders by CFTC Staff Relief:

Issues With FCM Margin Calls Prompt CME Clearing Disciplinary Action:

LedgerX Authorized to Offer Physically Settled Bitcoin Swaps to Retail Persons by CFTC Order:

Trading Firm Sanctioned by CFTC and CBOT for Purported Wash Trades After Individual Traders Warned to Stop:

Whistleblower Receives $2.5 Million From CFTC, but Delay in Reporting Penalized:

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of June 29, 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.

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Gary DeWaal

Gary DeWaal is currently Special Counsel with Katten Muchin Rosenman LLP in its New York office focusing on financial services regulatory matters. He provides advisory services and assists with investigations and litigation.

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