Bridging the Week by Gary DeWaal: Sept 9 - 13 and September 16, 2019 (Failure to Supervise; Misleading the CFTC; Audit Trail; Unauthorized Trading)

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Published Date: September 15, 2019

An interdealer broker agreed to pay a fine of US $13 million to the Commodity Futures Trading Commission to resolve charges that it failed to supervise brokers on a swaps desk that allegedly made numerous false or misleading statements to customers regarding executions, bids and offers. The CFTC also claimed the firm failed to respond adequately when an employee raised concerns regarding the conduct of the relevant desk to the firm's compliance department. Additionally, another employee of the firm purportedly provided false or misleading information to the CFTC during a voluntary interview related to the Commission’s investigation. Separately, a futures commission merchant was sanctioned US $300,000 by the CFTC for allegedly not producing requested complete audit trail records of a customer until almost three years after the Commission's initial request. As a result, the following matters are covered in this week’s edition of Bridging the Week:

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In one action, the CFTC claimed that, from at least October 2, 2012, through at least December 2014, Tullett failed to adequately supervise brokers on its US Dollar Medium-Term Interest Rates Swaps Desk who allegedly made numerous false and misleading statements to customers related to certain executed trades as well as bids and offers. Moreover, the CFTC claimed that in response to concerns raised by a Tullett employee to the firm’s compliance department in 2011 regarding such improper conduct prior to the relevant period, the firm took no meaningful action to augment its oversight and certain brokers on the relevant desk continued to provide false or misleading information to customers regarding executed trades, bids and offers.

Moreover, in the other action, the CFTC claimed that during its investigation into Tullett’s conduct, one unnamed broker make false or misleading statements or omitted material information to it during a voluntary appearance. The CFTC claimed that the broker had material information “regarding the practices at the heart of the investigation.” However, he purportedly made false or misleading statements or omitted material information after he was told the day before his interview by a co-head of the relevant desk to “just answer questions and not to go on and on about it.” The unnamed broker believed this was an instruction to “toe a line that protected Tullett.”

Tullett agreed to pay a fine of US $11 million to settle the CFTC’s action related to its failure to supervise and to enhance its supervision of the relevant desk to help prevent misleading information by brokers. Tullett separately agreed to a sanction of US $2 million to resolve the CFTC’s allegations regarding the false or misleading statements of one employee to the Commission’s staff.

Tullett Prebon is part of the TP ICAP Group.

Unrelatedly, the CFTC ordered Rafael Marconato, a non-US person, to pay a fine of US $25,000 and restitution of US $125,000 for engaging in acts that constituted a fraud on pool participants, and for making false statements to the National Futures Association regarding the nature of the activities of Phy Capital Investments LLC, a CFTC-registered commodity pool operator and commodity trading advisor. Mr. Marconato was the chief compliance officer and a registered associated person of Phy. Previously, the CFTC filed an enforcement action against Phy Capital and Fabio Bretas De Freitas, a principal of Phy, while the US Department of Justice filed a criminal complaint against Mr. Bretas, charging him with commodities fraud and other violations of law. (Click here for a copy of the CFTC complaint, and here for a copy of the criminal complaint.)

Culture and Ethics: It’s bad enough to violate legal requirements. It’s worse to lie about it.

First, it is expressly unlawful to make a false or misleading statement of a material fact to the CFTC or to omit information necessary to make any statement of a material fact not false or misleading. (Click here for Commodity Exchange Act § 6(c)(2), 7 U.S.C. § 9(2).) It is also a violation to engage in similar misleading conduct with a futures association like the NFA when it is conducting official business. (Click here to access CEA § 9(a)(4), 7 U.S.C. § 13(a)(4).)

Second, and frankly more importantly, being truthful to regulators is common sense. When an individual testifies formally or provides voluntary testimony to a regulator, he/she must be a truth machine. Listen to questions and respond honestly to the questions asked. Don’t be misleading. Anything else violates the law and is contrary to common sense.

According to the CFTC, ML maintained the audit trail data regarding orders and executions in its role as a registered futures commission merchant and executing broker for the relevant unnamed customer. However, the CFTC said that despite its Division of Enforcement’s agreement to limit the scope of the 2015 requests, ML did not produce complete audit trail data for the customer until January 2018. The FCM made some interim productions, but the data was incomplete, including containing unpopulated fields. ML recognized this problem in December 2017 and by the following month, produced the missing audit trail data. According to the Commission, ML’s almost three-year delay and data incompleteness were because the firm “lacked an adequate supervisory system to ensure the required records were properly kept and promptly produced.” Among other things, the CFTC claimed the firm did not have a process to identify account numbers or order entry operator identification numbers; defendant’s staff solely relied on their memories when searching for data. 

In agreeing to the settlement, the CFTC acknowledged ML’s representations that it has already taken certain remedial steps.

Compliance Weeds: In May 2017, the CFTC amended its recordkeeping requirements to eliminate many prescriptive requirements and to be “technology neutral” in order to accommodate future advances in recordkeeping technology. Among other things, the amended rule eliminated requirements that

  1. electronic records be maintained in their native file format and preserved exclusively in a non-rewritable, non-erasable format (commonly referred to as write once, read many or “WORM”); and
  2. records holders use a third-party technical consultant to provide certain representations to the Commission regarding access to a record holder’s required electronic records.

Instead, the amended rule solely requires that all “regulatory records” be maintained in a way that “ensures the authenticity and reliability of such regulatory record” in accordance with applicable law and CFTC regulations.

The CFTC’s amended rule applies to all records that applicable law or CFTC regulations generally require any person (including a legal entity, such as a corporation) to keep – whether a CFTC registrant or not (such records are termed “regulatory records” while such a person is referenced as a “records entity”). (Click here to access CFTC Rule 1.31.) A regulatory record includes all books and records required to be kept, as well as any correction or amendment, and for electronic records,

  1. any data necessary to access, search or display any such books and records; and
  2. all data produced and stored electronically describing how and when such books and records were created, formatted and modified.

However, to the extent other existing rules expressly relax certain recordkeeping obligations for certain persons, those rules continue to trump the new amended recordkeeping rule (e.g., recordkeeping obligations for trade option counterparties who are not swap dealers or major swap participants, or of unregistered members of exchanges regarding text messages and maintaining required records in a particular way; click here to access CFTC Rule 1.35(a)). (Click here to access more details on the CFTC amended recordkeeping requirements in the article “Principles-Based Rules Rule in CFTC Record Keeping Rule Amendment” in the June 4, 2017 edition of Bridging the Week.)

Separately, in December 2015, CME Group revised its Rule 536B.2 (click here to access) that authorizes a clearing member not to keep the electronic audit trail of its direct access clients that are other clearing members or equity member firms. Although at the time CME Group confirmed the rule’s provision that authorizes a clearing member “to notify [a] client Clearing Firm or Equity Member firm that it is their obligation to maintain the electronic audit trail” (emphasis added)—thus excusing the clearing member from maintaining the record—the exchange amended its rule to make clear this ability does not relieve a clearing member “from compliance with the applicable recordkeeping provisions of CFTC Regulations.” (Click here for more background regarding this rule amendment in the article “CME Group Amends Clearing Member Audit Trail Retention Requirements for Direct Access Clients—or Does It” in the December 20, 2015 edition of Bridging the Week.)

Subsequently, CME Group issued a revised Market Regulation Advisory Notice that was more blunt. It warned that “electronic order routing/front-end audit trail information must be provided to the CFTC pursuant to applicable CFTC recordkeeping provisions by an Exchange Clearing Member Firm (“CMF”), notwithstanding that [Rule 536B.2] permits a CMF to delegate the archiving and retention requirements for such audit trail to another CMF or Equity Member Firm in circumstances where the other firm is a direct connect client.” (Click here to access CME Group RA1520-5 (December 29, 2015).)

The CFTC claimed that Mr. Harris’s unauthorized trading constituted fraudulent conduct in violation of applicable law and an express CFTC rule. (Click here to access Commodity Exchange Act § 4b(a)(1)(A) and (C), 7 U.S.C. § 6b(a)(1)(A) and (C) and here for CFTC Rule 166.2.)

The CFTC also charged that, during August 2014, Mr. Harris’s unauthorized trading in one customer’s account exceeded speculative position limits for the August 2014 live cattle futures contract traded on CME.

During the relevant time, charged the CFTC, Mr. Harris entered orders for customers without obtaining their specific authorization prior to executing trades on their behalf; did not obtain written authorization from customers to trade their accounts on a discretionary basis; and on some occasions, established positions for customers that exceeded their verbal authority to trade for smaller quantities.

Previously, K&K and two of its co-owners – Bradley Kooima and Lauren Kaemingk – agreed to pay a fine of US $1.25 million, and restitution of US $11.9 million to resolve a CFTC enforcement action related to the IB’s purported unauthorized trading of customers’ accounts. At the time, CME also brought and settled disciplinary actions against the three respondents in the CFTC’s enforcement action for the same underlying facts. Under the CME’s settlement, the three respondents agreed to pay an additional US $1.25 million fine to the exchange. (Click here for background in the article “IB and Owners Resolve CFTC Charges for Unauthorized Trading by Former Employee” in the September 30, 2018 edition of Bridging the Week.)

In accepting Mr. Harris’s offer of settlement, the CFTC and the CME each imposed separate fines of US $1.25 million. The CME also barred Mr. Harris from accessing any of CME Group’s markets for 18 months, and from ever trading on a discretionary basis or entering orders for customers on CME Group markets. The CFTC similarly banned Mr. Harris for 18 months from trading on any market registered with it and other penalties.

Legal Weeds: Futures commission merchants and introducing brokers and their associated persons may only accept customer orders (1) if either the customer or a person specifically authorized by the customer to control the account specifies the exact commodity interest (e.g., futures, options on futures or swaps) and amount to be purchased or sold (2) or if they have been authorized in writing by the customer to effect transactions in commodity interests on the customer’s behalf. (See CFTC Rule 166.2.)

Similarly, no block trade order may be executed on behalf of an eligible customer unless the customer has expressly authorized the specific order to be executed as a block trade. (Click here to access, e.g., CME Group RA1908-SR containing CME Group Rule 526C and explanatory text in ¶ 2.)

More Briefly:

For further information

CFTC Directors Again Address Margining of Multiple Accounts of Same Owner:

Court Denies Summary Judgment Motion of Purported Programmer for Flash Crash Spoofer – For Now:

FCM Sanctioned US $300,000 by CFTC for Alleged Delayed Production and Incomplete Audit Trail Data:

Interdealer Broker Fined US $13 Million by CFTC for Making False or Misleading Statements to Customers and to CFTC:

Previously Unnamed IB Employee Fined US $2.5 Million by CFTC and CME for Unauthorized Trading Causing Over US $10 Million in Customer Losses:

SEC Propose Rules to Avoid Further Delays to CAT Rollout:

Trading Firm Sanctioned by NYSE Chicago for Purported Temporary Net Capital Deficiency Cause by Erroneous Algo Fix:

US Appeals Court Finds No US Nexus for Private Manipulation Allegations Under Commodity Exchange Act:

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of September 14, 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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