Bridging the Week by Gary DeWaal: November 25 to December 6, and December 9, 2019 (CCO Annual Reports; Target Practice; Unintentional Breakdown)

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Published Date: December 08, 2019

The Commodity Futures Trading Commission issued revised guidance for mandatory chief compliance officer annual compliance reports for futures commission merchants and swap dealers. However, the proposed recommendations are not as significant as a look-back on how compliance officers and CCO annual reports seemed to have become heightened targets of the CFTC’s Division of Enforcement in fiscal year 2019. Separately, a swap dealer was fined US $1 million by the CFTC for failing to make and retain audio recordings of certain oral communications of its swaps trading and related cash and forwards transactions for 20 business days. However, given the inadvertence of the incident and the firm’s self-discovery and response to its breakdown within just a few weeks, was this really a matter warranting an enforcement action, let alone a US $1 million fine? As a result, the following matters are covered in this week’s edition of Bridging the Week:

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DSIO principally addressed those portions of the CCO annual reports dealing with (1) areas for improvement; (2) prospective changes or improvements to compliance programs; (3) financial, managerial, operational and staffing resources; (4) material noncompliance issues; and (5) material changes to compliance policies and procedures. Staff also included recommendations regarding the CCO’s annual report’s certification requirement and other matters. (Click here to access relevant CFTC regulations regarding the CCO annual report, in CFTC Rule 3.3(e) and (f).)

All FCMs and SDs must appoint a CCO. Among the required duties of a CCO is to prepare and sign an annual compliance report. These reports must be filed with the Commission by no later than 90 days after each FCM’s and SD’s fiscal year-end and contain a certification by the firm’s CCO or chief executive officer that, to the best of his or her knowledge and reasonable belief, all information contained in the annual report is materially accurate and complete. Other CFTC-regulated entities also have obligations to submit CCO annual reports to the Commission (e.g., derivatives clearing organizations and swap execution facilities; click here to access CFTC Rule 39.10(c)(3) and (4)) and here to access CFTC Rule 37.1501(e) and (f)). However, the CFTC’s revised guidance is expressly applicable solely to FCMs and SDs (although the guidance is helpful to CCOs of all registered entities that must file an annual compliance report with the CFTC).

In its guidance, DSIO was most critical of FCMs’ and SDs’ discussions of “areas for improvement” (see CFTC Rule 3.3(e)(3)). Staff said that registrants “often” failed to provide context around why a matter warranted improvement, what the current status of the improvement was; and what CFTC regulation was associated with the matter. DSIO also observed that registrants “commonly” included their discussion of areas for improvement in the section of the CCO annual report dedicated to the FCM’s or SD’s assessment of the effectiveness of their policies and procedures (see CFTC Rule 3.3(e)(2)). However, said DSIO, areas for improvement are not restricted to policies and procedures or material noncompliance issues. 

Moreover, noted DSIO, registrants must not only identify areas for improvement but also recommend changes for improvement. Although staff has seen recommendations set forth in different ways, it recommends including discussions of potential or prospective changes or improvements in a stand-alone section. Any recommendation that would require a change in resources dedicated to a firm’s compliance program should discuss the resources in this section of the CCO annual report.

DSIO also said that:

For convenience, DSIO included a stand-alone checklist of common deficiencies in CCO annual reports and a list of all staff recommendations in an appendix to its guidance.

DSIO issued initial guidance regarding CCO annual reports in 2014. (Click here for background in the article “In Time for Christmas, CFTC Staff Gives FCMs, SDs and MSPs Gift of Time Extension to File CCO Annual Report; However, Adds Content Requirements as the Price” in the January 2, 2015 edition of Between Bridges.) The CFTC refreshed this guidance in 2018 when it amended its rules related to CCOs and their annual compliance reports. (Click here for background in the article "CFTC Amends Rules to Simplify CCO Duties and Annual Report Obligations of FCMs, SDs and MSPs" in the August 26, 2018 edition of Bridging the Week.)  

DSIO’s guidance is also technically applicable to major swap participants; however, there are currently none registered.

Compliance Weeds: Since late 2018, the CFTC has expressly identified deficiencies in CCO annual reports in enforcement actions, and highlighted the role of compliance officers in contributing to their firms’ alleged regulatory violations.

In November 2018, Commerzbank AG agreed to pay a fine of US $12 million to the CFTC to resolve charges that, from December 31, 2012 through at least 2018, it failed to comply with various requirements for swap dealers, and for two years it filed chief compliance officer annual reports that did not “adequately disclose” deficiencies in compliance of which it was aware. 

According to the CFTC, during “much” of the relevant time Commerzbank failed to have an “effective, bank-wide process” to evaluate whether its transactions with certain non-US persons were subject to requirements for swaps under applicable law. Additionally, the CFTC claimed that in 2015, Commerzbank filed a CCO annual report for 2014 that failed to identify material compliance issues identified for the bank in 2014 by an outside consultant that had been retained to evaluate its policies and procedures for adherence to applicable requirements. The CFTC also said that Commerzbank’s 2015 CCO annual report filed in 2016 did not disclose problems with the bank’s large trader reporting compliance that Commerzbank identified in March 2015. 

(Click here for background in the article “Swap Dealer Agrees to Pay US $12 Million to CFTC for Noncompliance With Multiple Regulatory Requirements and Allegedly Filing Misleading Annual Compliance Reports” in the November 11, 2018 edition of Bridging the Week.)

More recently, RBC Capital Markets LLC – a registered futures commission merchant and a wholly owned indirect subsidiary of the Royal Bank of Canada – agreed to pay a fine of US $5 million to the CFTC for allegedly engaging in 385 instances of wash sales involving exchange for physical transactions in interest rate products from December 2011 through October 2015.

In addition to charging RBCCM with violations of applicable law and relevant CFTC regulations for failure to supervise, wash sales and conducting EFPs not in accordance with CME rules, the Commission claimed that the firm failed to disclose certain material compliance issues in its 2015 and 2016 CCO annual report, among other violations. (Click here for additional background in the article “CFTC Settles Avalanche of Enforcement Actions Alleging Failure to Supervise, Spoofing, Reporting Violations and Providing Misleading Information to the CFTC and FCMs” in the October 6, 2016 edition of Bridging the Weeksee section “Purported Failure to Supervise”.)

At the same time the CFTC filed its enforcement action against RBCCM, it announced enforcement actions against two other registrants. In all three actions the CFTC singled out the acts of the compliance department and/or a compliance officer as contributing to a registrant’s alleged substantive violations. 

In an action against The Northern Trust Company, a provisionally registered swap dealer, the CFTC charged the firm with a failure to comply with certain reporting requirements under CFTC rules. The Commission claimed that Northern Trust’s purported reporting issues were attributable to its “failure to devote adequate attention and resources to reporting solutions.” In addition to reporting violations, the CFTC charged Northern Trust with failure to supervise. The CFTC said that the swap dealer’s supervisory breakdown was aided, in part, because the firm “repeatedly hired compliance personnel for the [swap dealer] who possessed some financial industry and regulatory experience, but lacked the specific technical expertise necessary to ensure [swap dealer] compliance.” (For more details, reference the article in Bridging the Week identified above; see section “Claimed Reporting Infractions”.)

Likewise, the CFTC brought and settled enforcement actions against Classic Energy LLC, a registered introducing broker, and Mathew Webb, its former founder, president and sole member, for purportedly defrauding Classic’s customers by executing 63 block trades between customers and a Classic proprietary account based on nonpublic information and for trading opposite Classic’s customers in block trades without disclosing that Classic was acting as a counterparty and not as a broker – the category the clients expected. The CFTC charged Classic with failure to maintain records of block trades and failure to supervise. Among other things, the CFTC claimed that Classic’s compliance officer did not conduct sufficient checks of a system used by a third party retained to maintain audio recording of block trades for Classic to ensure that communications were being prepared and maintained as required.

Classic and Mr. Webb agreed together to pay an aggregate fine of US $1.5 million to resolve the CFTC’s enforcement action. (For more details, reference the article in Bridging the Week identified above; see section “Misappropriation Charged”.)

All these actions highlight the importance of FCMs and SDs getting it right in their CCO annual reports, and of compliance officers being well-trained, empowered and diligent.

According to the CFTC, GSC’s failure was initiated by the firm’s installation of a security patch on certain software used in one of its offices. This installation required the shutdown and restart of its servers. However, as a result of this process, GSC’s hardware to record oral communications failed as did the hardware’s failsafe alarm meant to alert the firm of a failure and to start a backup recording system. The CFTC acknowledged that “[a]t the time, Goldman had followed the vendor’s configuration instructions and was unaware of the vulnerability of the recording hardware it utilized [to malfunction as it did].”

A few weeks later, following an internal move by certain personnel in the affected office, GSC tested its recording system and learned of the breakdown. The CFTC said that the firm re-engaged the recording system by early morning on the day following its discovery of the breakdown and instituted “a number of measures” to preclude a repeat error and to detect a breakdown promptly should it occur.

The CFTC claimed that GSC’s recording breakdown “impeded” a subsequent, unrelated investigation it conducted. However, the CFTC also conceded it was able to capture some of the relevant recordings through recorded lines in other GSC offices.

My View: In its FY 2019 annual report published on November 25, the CFTC’s Division of Enforcement wrote that a “strong enforcement program, is … about preserving market integrity, protecting customers, and deterring misconduct in the first place. It’s about being tough, but it’s also about being fair.” (Click here to access the DOE annual report.)

Unfortunately, even the best designed technology breaks down or fails to operate as intended from time to time. As a result, it seems unfair for the CFTC to bring this enforcement action against a company (let alone fine it US $1 million) where the firm relied on third-party hardware that malfunctioned; a backup system failed to kick in as designed through no fault of the firm; the company self-discovered its problem within a short time and promptly fixed it; and the firm on its own initiative revised its processes to help avoid a similar future issue.

As the CFTC’s Enforcement Division also wrote in its Annual Report, “it’s about allocating resources to ensure our efforts target the most pernicious forms of misconduct.” The CFTC said GSC’s failure to record and maintain certain oral recordings allegedly hindered an unrelated DOE investigation; this is unfortunate and may have warranted a warning or other similar measure. However, the firm’s overall conduct associated with this recording breakdown hardly seems sufficiently “pernicious” to have warranted more.

The DOE claimed that during the last fiscal year, its priorities were the same as FY 2018: (1) ensuring market integrity, (2) protecting customers, (3) encouraging individual accountability, and (4) enhancing coordination with other regulators and criminal authorities. Fifty-one of the cases it brought addressed purported manipulative conduct and spoofing; commodities fraud; misappropriation of confidential information, trade allocation schemes and mismarking; and protection of customer funds, supervision and financial integrity,

Among other areas of focus, the DOE said it “aggressively” pursued purported misconduct involving digital assets regarded as “commodities” under applicable law as well as misappropriation of confidential information.

In its annual report, the DOE noted that the CFTC awarded over US $15 million in whistleblower awards last fiscal year.

Separately, the National Futures Association also issued its 2019 Annual Review. The NFA claimed its major accomplishments this year included (1) the announcement of its swap proficiency requirements for all persons acting as associated persons at swap dealers and registered APs engaged in swaps activities at futures commission merchants, commodity trading advisors and commodity pool operators; (2) its update of its BASIC system that captures registration and disciplinary information on firms and professionals in the derivatives markets; and (3) the amendment of its interpretive notice regarding the supervision of branch offices and guaranteed introducing brokers.

(Click here for background regarding NFA’s swap proficiency requirements in the article “NFA Seeks Smarter Swaps APs Through New Training Requirements” in the March 20, 2019 edition of Bridging the Week. Click here for background on the new supervisory requirements in the article “NFA Proposes Overhaul of Requirements for Supervision of Branch Offices and Guaranteed IBs” in the June 9, 2019 edition of Bridging the Week.)

Compliance WeedsThrough publication of its annual report, the CFTC’s DOE endeavors to be transparent about its priorities. Persons involved in US derivatives markets should use this publication to evaluate the adequacy of their policies and procedures to help ensure, at a minimum, they align with the DOE’s priorities.

Earlier this year, the DOE also issued a reference guide setting forth policies and procedures regarding the conduct of investigations, the prosecution and settlement of enforcement actions, and miscellaneous topics, such as ethics, confidentiality and records management.

The Enforcement Manual did not break any new ground. However, it is an additional useful tool for industry participants and represents another welcome effort by the DOE to be transparent. (Click here for further background on the Enforcement Manual in the article “CFTC Division of Enforcement Issues First Guide to Activities and Overview of General Policies and Procedures” in the May 12, 2019 edition of Bridging the Week.)

More Briefly:

According to an affidavit of a special agent of the Federal Bureau of Investigation incorporated in a complaint filed against Mr. Griffith in a federal court in New York City, Mr. Griffith surreptitiously travelled to North Korea in April 2019 through China after being denied approval to do so directly by the US Department of State. He presented at a conference there entitled “Blockchain and Peace,” and discussed, among other topics, how blockchain technology, including smart contracts, could be used to benefit North Korea.

If convicted, Mr. Griffin could be subject to imprisonment of up to 20 years.

‚ÄčIn again requesting an order for summary judgment, defendants argued that they have made a substantial additional production of documents since their last motion, including providing the CFTC – at Mr. Thakkar's own expense – with more than 800,000 pages of documents given to Mr. Thakkar by the DOJ during his criminal action. 

In response, the CFTC asked that the court deny defendants' motion, arguing that there are still open discovery issues and that it desires to take the depositions of four former Edge employees who helped develop and test the software Mr. Thakkar purportedly designed for Mr. Sarao. The CFTC claimed that the results of the discovery and testimony could help "in shedding light" on Mr. Thakkar's understanding of Mr. Sarao's trading objectives.

The new rules are meant to provide a uniform set of conditions for registered funds to engage in derivatives transactions by requiring the adoption and maintenance of a written derivatives management program, and compliance with an outer limit on fund leverage based on a value at risk test that would cap a fund’s VaR to 150 percent of a designated reference index for the fund. There would be an exception from the management program requirement and VaR limit cap for funds that limit their derivatives exposure to 10 percent of their net assets or use derivatives solely to hedge certain currency risks. There would also be alternative conditions for certain leveraged or inverse funds.

The proposed rules would also mandate a set of due diligence and approval requirements for broker-dealers and investment advisers in connection with trades in shares of leveraged investment vehicles and include a hard cap on geared products’ employment of leverage at three times a specified market index. Commissioners Hester Peirce and Elad Roisman raised concerns regarding these restrictions, noting the sales practice requirements are proposed to apply even when an investor determines to invest in a geared ETF without input from a broker or investment adviser. According to the commissioners, “[t]he SEC protects investors not by limiting their right to access products available in public markets, but by ensuring that they have material information at the ready to make informed buy, sell and hold decisions.” (Click here to access Commissioners Peirce and Roisman’s statement.)

Comments will be accepted on the SEC’s proposal for 60 days following its publication in the Federal Register.

The SEC previously proposed a rule aimed at limiting the leverage registered investment companies could obtain through the use of derivatives transactions in 2015. (Click here for background in the article “SEC Considers New Rule to Restrict Use of Derivatives by Investment Companies” in the December 13, 2015 edition of Bridging the Week.)

Separately, NFA also reminded persons that claim certain exemptions from registration as a commodity trading advisor or commodity pool operator to affirm their exemption by February 29, 2020. Failure to do so will result in withdrawal of the exemption on March 1, 2020.

Unrelatedly, Goldman Sachs & Co. LLC agreed to pay a fine of US $15,000 for entering into an exchange for risk on July 9, 2018, where the related positions allegedly did not have a “reasonable degree of price correlation” and “opposing market bias” to the exchange portion of the transaction and where in an exchange of option for option transaction the related component was not “reasonably equivalent” to the exchange element. Finally, Hong Yang agreed to pay a fine of US $25,000 and be suspended from access to all CME Group trading facilities for 30 days for permitting one or more persons to use his Tag50 identification for trading activity from October 9 through December 5, 2016.

For further information:

Based on Experience, CFTC Staff Makes Recommendations of Better Practices for FCMs’ and Swap Dealers’ Chief Compliance Officer Annual Compliance Reports:

CFTC FY 2019 Enforcement Annual Report Highlights High Percentage of Cases Aimed at Promoting Market Integrity:

NFA Proposes to Apply Rules Related to Discretionary Customer Accounts to Cleared Swaps; Reminds Exempt CTAs and CPOs to Affirm Exemptions:

Nonmember Sanctioned by COMEX for Spoofing and Misusing Tag50 Identification of Another Trader

Programmer for Flash Crash Spoofer Renews Motion to Dismiss CFTC Enforcement Action:

Registrant Penalized US $1 Million by CFTC After Finding and Fixing Inadvertent Short-Term Audio-Recording Breakdown:

Renowned Ethereum Backer Criminally Charged for Purportedly Traveling to North Korea and Training on Use of Cryptocurrencies and Blockchain to Evade Economic Sanctions:

SEC Again Proposes to Authorize Use of Derivatives by Registered Investment Companies:

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of December 7, 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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