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Bridging the Week: August 20 to 24 and August 27, 2018 (CCOs; Annual Compliance Report; Bitcoin Futures ETPs; Reg SHO: Virtual Currency)

The Commodity Futures Trading Commission revised its rule related to the responsibilities of chief compliance officers of futures commission merchants, swap dealers and major swap participants, as well as the obligations of such registrants for the annual compliance reports they are mandated to prepare and file with the CFTC. The goal is to make the rule simpler and clearer. Separately, on August 22, the Securities and Exchange Commission through its staff declined to approve two exchanges’ proposed rule changes to authorize the listing and trading of nine exchange-traded products based on CFTC-sanctioned bitcoin futures contracts. However, the following day, the SEC suspended its disapproval pending the full Commission’s review. As a result, the following matters are covered in this week’s edition of Bridging the Week:

  • CFTC Amends Rules to Simplify CCO Duties and Annual Report Obligations of FCMs, SDs and MSPs (includes My View);

  • SEC Declines to Approve Two Exchanges' Rules Authorizing Nine Bitcoin Futures ETPs (includes My View); 

  • FINRA Fines Broker-Dealer US $5.5 Million for Purported Reg SHO Errors and Supervisory Lapses (includes Compliance Weeds); 

  • Federal Court Enters Final Judgment Against Alleged Virtual Currency Fraudster; Confirms CFTC Authority to Bring Enforcement Action (includes Legal Weeds); and more.

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Briefly:

  • CFTC Amends Rules to Simplify CCO Duties and Annual Report Obligations of FCMs, SDs and MSPs: The Commodity Futures Trading Commission proposed amendments to its rule that details the requirements of chief compliance officers of futures commission merchants, swap dealers and major swap participants, as well as the obligations of such entities related to their preparation and submission of annual compliance reports to the CFTC. The goal of such rule changes is to make applicable obligations simpler and clearer. The CFTC also endeavored to better align its CCO and annual compliance report requirements with those of the Securities and Exchange Commission. (Click here to access the applicable CFTC Rule, 3.3.)

Among other things, the CFTC:

  • clarified when the applicable rule requires that the CCO report to the board of directors or the “senior officer” of the registrant; senior officer means the chief executive officer or other equivalent officer;

  • eliminated the existing requirement that a registrant addresses each applicable CFTC requirement that it is subject to in its annual compliance report when evaluating its written policies and procedures. However, according to the CFTC, “the CCO must still conduct an underlying assessment of the policies and procedures to meet the requirement of the rule.” Additionally, the Commission clarified that the annual report’s discussion of compliance resources can be limited to resources relevant to the specific activities of the registered organization (i.e., FCM, SD and/or MSP);

  • consistent with SEC requirements, made clear that a CCO’s obligations to resolve conflicts of interests applies only to material conflicts and imposes an obligation on the CCO solely to take “reasonable steps” to resolve such conflicts. The CFTC also eliminated the obligation of CCOs to consult with the board of directors or senior officer to establish procedures to address non-compliance issues and amended its rule to require a CCO solely to “take reasonable steps” to ensure that a registrant establishes and maintains written policies and procedures for the remediation of non-compliance issues.

The CFTC declined to define what constituted a material “non-compliance issue” in connection with the obligation of relevant registrants to describe such matters in their annual CCO compliance report. The CFTC said that one size does not fit all, and providing a definition “could result in an overly prescriptive model for many Registrants.”

The CFTC’s new requirements will be effective 30 days after the date they are published in the Federal Register. (Click here for background on the CFTC’s initial proposed amendments in the article “CFTC Recommends Amendments to CCO Obligations and Annual Reports” in the May 7, 2017 edition of Bridging the Week.)

My View: The final amended CCO and annual compliance report rule adopted by the CFTC provides some substantial clarification and simplification of existing requirements. However, as noted by the CFTC in its adopting release, unlike the relevant law related to swap dealers and MSPs, the law related to FCMs expressly permits CCO functions and obligations to be prescribed by a registered futures association (i.e., the National Futures Association) as well as by the CFTC (click here to access Commodity Exchange Act Section 4d(d), 7 U.S.C. § 6d(d)).

As I have previously advocated, the CFTC should consider delegating all matters related to FCM CCOs, including preparation of the annual report, to NFA. This would more closely align futures industry practice for FCMs to securities industry practice related to broker-dealers and allocate some oversight functions related to FCMs from the CFTC to NFA where, in light of CFTC budget restraints, they may more economically and efficiently belong. (Click here for access to Rule 3130 of the Financial Industry Regulatory Authority entitled “Annual Certification of Compliance and Supervisory Processes.”)

  • SEC Declines to Approve Two Exchanges' Rules Authorizing Nine Bitcoin Futures ETPs: The Securities and Exchange Commission declined on August 22 to approve rule amendments proposed by NYSE Arca, Inc. and Cboe BZX Exchange, Inc. to authorize the listing and trading of shares of nine exchange-traded funds that planned to seek exposure to some or all of the bitcoin futures contracts traded on the Chicago Mercantile Exchange, Cboe Futures Exchange and/or any other US exchange that subsequently traded such contracts. This denial was by the SEC’a Division of Trading and Markets pursuant to “delegated authority.” However, on August 23, the Commission stayed staff’s denial and indicated it would review the delegated action (click here for a sample stay order).

Generally, said the SEC, where there is risk of manipulation in a market relevant to an ETP, the listing securities exchange should have a surveillance-sharing agreement with a regulated market of significant size in order to “provide a necessary deterrent to manipulation because [such agreements] facilitate the availability of information to fully investigate a manipulation if it were to occur.”

However, although acknowledging that both CME and CFE are markets regulated by the Commodity Futures Trading Commission, SEC staff said they were not markets of significant size because of their relative newness and low volume. Thus, claimed SEC staff, surveillance-sharing agreements with CME and CFE did not meet the SEC’s requirements.

In evaluating the CME and CFE bitcoin futures contracts, the SEC considered the median daily notional trading volume from the contracts’ inception in December 2017 through August 10. However, on CME, the daily notional value of bitcoin futures contracts traded materially increased 93 percent from the first to second quarter, averaging a notional volume of 17,885 bitcoins and an open interest of 12,025 bitcoins/day during the second quarter. (Click here for further details; each CME bitcoin futures contract is based on five bitcoin.) The SEC said it was difficult to compare the notional size of the CME and CFE bitcoin futures markets with the overall size of the spot bitcoin market.

Earlier this month, the SEC disapproved a proposed rule change by the Bats BZX Exchange, Inc. to permit its listing and trading of shares of the Winklevoss Bitcoin Trust. The SEC denied BZX’s application, claiming that its proposed rule change was not consistent with requirements of applicable law, mainly “to prevent fraudulent and manipulative acts and practices” and “to protect investors and the public interest.” (Click here for background in the article “SEC Says 'No' to Winklevoss Bitcoin Trust While NFA Says 'Yes' to Intermediaries’ Crypto Businesses but Requires Disclosures” in the August 5, 2018 edition of Bridging the Week.) In a dissenting opinion, Commissioner Hester Peirce criticized the Commission for focusing its attention on spot markets in bitcoin, and not on the ability of the exchange listing the relevant ETP to detect and deter potential manipulation. (Click here to access Ms. Peirce's opinion.)

My View: I am not clairvoyant and have no crystal ball that tells me whether bitcoin or any altcoin will succeed or fail. Likewise, I have no particular insight into whether bitcoin or any altcoin traded peer to peer on a relevant blockchain or on any particular spot exchange is more or less susceptible to manipulation than any other commodity on which a futures contract today may be based. That being said, certainly on some spot crypto exchanges – those licensed by the New York Department of Financial Services – there is an express obligation for regulated entities to surveil markets for potential improprieties. (Click here for background in the article “NYS Financial Services Regulator Ups the Obligations of State-Licensed Virtual Currency Entities” in the February 11, 2018 edition of Bridging the Week.)

However, in any case, the proposed ETPs disallowed by the SEC are not based on spot bitcoin prices; they are based on bitcoin futures prices derived from trading on exchanges regulated by the CFTC.

Although there may be reasonable doubt as to the surveillance capabilities of spot bitcoin exchanges at this point despite evolving requirements, both CME and CFE, as part of their self-certification process to be allowed to trade bitcoin futures, affirmed that their contracts complied with relevant law and CFTC requirements, including that their contracts were not readily susceptible to manipulation. The CFTC did not challenge this self-certification. Moreover, the exchanges’ certification reflected their acknowledgment that they had “the capacity and responsibility to prevent manipulation, price distortion, and disruptions of the delivery or cash-settlement process through market surveillance, compliance practices and procedures.” (Click here to access Core Principle 4 for designated contract markets, Appendix B to CFTC Part 30 rules.)

Additionally, as part of the self-certification process of CME’s and CFE’s bitcoin futures contracts, both exchanges apparently “agreed to significant enhancements to contract design and settlement … at the request of Commission staff, as well are more information sharing with the underlying cash bitcoin exchanges to assist [the exchanges] and the CFTC in surveillance.” (Click here for background in the “CFTC Statement on Self-Certification of Bitcoin Products by CME, CFE and Cantor Exchange," (December 1, 2017). Click here for a related CFTC Backgrounder.)

Notwithstanding, SEC staff declined to approve ETPs based on such bitcoin futures contracts because, supposedly, NYSE Arca and Cboe BZX Exchange did not have surveillance sharing agreements with markets of significant size. The SEC cited the low volume and open interest of CME’s and CFE’s relatively new bitcoin futures contracts to support its position. However, very few new futures contracts start with very high volume and at least the CME’s bitcoin futures contract appears to be growing in popularity.

In light of applicable CFTC requirements, it seems reasonable where an ETP is based on a futures contract traded on a CFTC-regulated exchange, that an information sharing agreement with such an exchange should be sufficient to satisfy a listing securities’ exchange’s obligation to ensure its rules are “designed to prevent fraudulent and manipulative acts and practices [and] to protect investors and the public interest.” (Click here to access Securities Exchange Act Rule § 6(b)(5), 15 U.S. Code § 78f(b)(5).) Hopefully, when the full Commission reconsiders its staff’s determination, it will give more deference to the CFTC’s requirements and practices and at least not use the purported lack of a surveillance sharing agreement with a market of significant size as a basis to decline these new products.

  • FINRA Fines Broker-Dealer US $5.5 Million for Purported Reg SHO Errors and Supervisory Lapses: Interactive Brokers LLC agreed to pay a fine of US $5.5 million to the Financial Industry Regulatory Authority to settle allegations that, from July 2012 through June 2015, it purportedly failed to comply with certain aspects of the Securities and Exchange Commission’s Regulation SHO, and failed to have and follow written supervisory procedures reasonably designed to detect such failures. Moreover, said FINRA, the firm failed to act on red flags of relevant failures, including internal audit findings and “multiple internal warnings” from the firm’s clearing and compliance departments. 

IB is a broker-dealer licensed by the Securities and Exchange Commission and a member of FINRA.

Among other things, Reg SHO generally requires broker-dealers to close out short sales where delivery of the quantity of the relevant security has not occurred (a so-called “failed to deliver” or “FTD”) by borrowing or purchasing the same quantity of a like-kind security by the beginning of regular trading hours on the settlement day following the settlement date. (Click here to access SEC Rule 204(a), and here for 17 CFR 242.204(a).) The SEC claimed that, during the relevant time, IB failed to close out open FTDs on at least 2,329 occasions.

Moreover, Reg SHO also prohibits a broker-dealer from engaging in short sales in a security subject to an FTD without first borrowing or arranging to borrow the security. FINRA claimed that IB violated this requirement on approximately 28,000 occasions during the relevant time because its automated systems incorrectly gave credit for borrows that were not delivered and thus did not correct the FTD.

IB agreed to the FINRA settlement without admitting or denying any findings.

Compliance Weeds: Under Reg SHO (click here to access this regulation at 15 USC §§ 242.200 - 242.204), 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. Broker-dealers comply with this so-called “locate requirement” by maintaining so-called “easy to borrow” lists, which set forth equity securities they reasonably believe they can borrow. Absent an authorized basis, brokers that are participants on a registered clearing agency must close out FTD transactions by no later than the beginning of trading on the settlement day following settlement day of the relevant securities (T+3). However, if the participant can demonstrate that a fail occurred from a long sale or is attributable to bona fide market maker activities, it must close out the relevant securities by no later than the beginning of trading on the third consecutive settlement following the settlement date (T+5). Many other very technical requirements may apply. (Click here for background regarding Reg SHO in an SEC publication, Key  Points About Regulation SHO.)

  • Federal Court Enters Final Judgment Against Alleged Virtual Currency Fraudster; Confirms CFTC Authority to Bring Enforcement Action: A federal court in Brooklyn, New York, entered an order of permanent injunction, imposed a civil penalty of approximately US $871,000, and ordered restitution of approximately US $290,000 against Cabbagetech Corp. and Patrick McDonnell, its owner and controller, in connection with a lawsuit brought by the Commodity Futures Trading Commission that charged the defendants with unlawfully soliciting customers to send money and virtual currencies for virtual currency trading advice and for the discretionary trading of virtual currencies. However, alleged the CFTC, the defendants did not provide the promised services and misappropriated their customers’ funds.

In ruling against the defendants, the federal court again held that virtual currencies are commodities and that the CFTC had jurisdiction to bring its enforcement action relying on the fraud-based manipulation prohibition in the Dodd-Frank Wall Street Reform and Consumer Protection Act and a parallel CFTC rule. (Click here to access Commodity Exchange Act Section 6(c)(1), 7 U.S.C. § 9(1) and here for CFTC rule 180.1)

Previously, defendants had made a motion to dismiss the CFTC’s case on the grounds that the Commission had no authority to bring its action. In March, however, the court upheld the authority of the CFTC to exercise its enforcement power in connection with alleged fraud in the sale of virtual currencies in interstate commerce even where the purported wrongdoing related to spot transactions in such commodities and not derivatives based on such commodities. (Click here for further background in the article “A Court, Treasury and the SEC Confirm Substantial Overlap in US Jurisdiction of Cryptocurrencies” in the March 8, 2018 edition of Between Bridges.)

Mr. McDonnell subsequently requested a reconsideration of the court’s ruling based on a May 1, 2018, federal court decision in California involving Monex Deposit Company and other defendants. There, the court held that the CFTC could not use the fraud-based manipulation prohibition adopted as part of Dodd-Frank to prosecute acts of purported fraud alone; a detrimental market impact must also be alleged. However, the Brooklyn federal court rejected Mr. McDonnell’s request for reconsideration noting that it took a different view than the California court regarding the CFTC’s authority. (Click here for background in the article “Federal Court in Brooklyn Rejects Application of California Decision as Basis to Dismiss Pending CFTC Cryptocurrency Fraud Suit” in the July 22, 2018 edition of Bridging the Week.)

Mr. McDonnell generally represented himself in the CFTC litigation without the assistance of counsel.

Legal Weeds: Decisions in response to motions to dismiss are still outstanding in two important enforcement actions involving cryptocurrencies where defendants challenge the jurisdiction of the CFTC and the Securities and Exchange Commission over certain crypto tokens.

A federal court in Massachusetts is expected to rule soon on a motion to dismiss made by Randall Crater and the relief defendants in the CFTC’s My Big Coin Pay, Inc. enforcement action filed earlier this year. In that action, the CFTC claimed that My Big Coin Pay, Inc. and two persons closely involved with the company – Mr. Crater and Mark Gillespie – allegedly engaged in a virtual currency scheme that misappropriated approximately US $6 million from 28 or more persons from at least January 2014 through January 2018.

Mr. Crater and the relief defendants argued in papers to support a motion to dismiss that the CFTC has no jurisdiction to bring its enforcement action alleging fraud in connection with the sale of the virtual currency known as “My Big Coin,” because the virtual currency was not a commodity under applicable law. This is because, said the defendants, the virtual currency was neither a good nor an article, service, right or interest in which contracts for future delivery are dealt in. If My Big Coin is not a commodity, the CFTC had no authority to prosecute a fraud case against them under applicable law, claimed the defendants.

The defendants also argued that the CFTC had no standing to bring a general anti-fraud case against them relying on a fraud-based manipulation prohibition adopted as part of Dodd-Frank. (Click here for background in the article “CFTC Sues Unregistered Company and Promoters of Fake Virtual Coin for Alleged Fraud and Operating Purported Ponzi Scheme” in the January 28, 2018 edition of Bridging the Week.)

Separately, Maksim Zaslavskiy moved to dismiss a criminal complaint that had been filed against him in November 2017, charging that he engaged in illegal unregistered securities offerings and securities fraud in connection with the offering of digital tokens through initial coin offerings organized by two of his companies, REcoin Group Foundation, LLC and DRC World, Inc. Among other things, Mr. Zaslavskiy claimed in his motion that the digital tokens he tried to create were not securities but cryptocurrencies and that all currencies – fiat and otherwise – are not securities under applicable law. (Click here for background in the article “Federal Court, Treasury and SEC Provide Further Guidance on Cryptocurrencies; Subject of Criminal Complaint for ICO Asks Court to Dismiss Prosecution Claiming Cryptocurrencies Are Not Securities” in the March 11, 2018 edition of Bridging the Week.)

More Briefly:

  • CFTC Exempts Smaller Bank Holding Companies, S&L Holding Companies and Community Development Financial From Swap Clearing Requirement: The Commodity Futures Trading Commission proposed rule amendments that would exempt from clearing requirements swaps entered into by bank holding companies and savings and loan associations with consolidated assets of US $10 billion or less and community development financial institutions that meet certain requirements. Comments on the CFTC rule proposal will be accepted for 60 days after their publication in the Federal Register.

  • NFA Amends Security Futures Risk Disclosure: The National Futures Association proposed amendments to its Interpretive Notice entitled “Risk Disclosure Statement for Security Futures Contracts.” (Click here to access this Interpretive Notice.) The amended disclosure statement reflects that the Securities Investor Protection Corporation coverage for securities held in securities accounts, including security futures contracts, continues to be limited to up to US $500,000. However, where previously only up to US $100,o00 of that amount covered cash, the potential covered cash component was recently increased to US $250,000. (Click here for details.) The NFA submitted its proposed amendments to the CFTC on August 21; absent CFTC objection, NFA may implement its new interpretive notice 10 days after the

  • Commission’s receipt of the proposed amendments.


For further information

CFTC Amends Rules to Simplify CCO Duties and Annual Report Obligations of FCMs, SDs and MSPs:
https://www.cftc.gov/sites/default/files/2018-08/federalregister082118.pdf

CFTC Exempts Smaller Bank Holding Companies, S&L Holding Companies and Community Development Financial From Swap Clearing Requirement:
https://www.cftc.gov/sites/default/files/2018-08/federalregister082318.pdf

Federal Court Enters Final Judgment Against Alleged Virtual Currency Fraudster; Confirms CFTC Authority to Bring Enforcement Action:
https://www.cftc.gov/sites/default/files/2018-08/enfdropmarketsmemorandum082318.pdf
https://www.cftc.gov/sites/default/files/2018-08/enfdropmarketsorder082318.pdf

FINRA Fines Broker-Dealer US $5.5 Million for Purported Reg SHO Errors and Supervisory Lapses:
http://www.finra.org/sites/default/files/Interactive_AWC_081718.pdf

NFA Amends Security Futures Risk Disclosure:
https://www.nfa.futures.org/news/PDF/CFTC/InterpNotCR2-30bRiskDisclsoureStatementSecurityFuturesContracts082018.pdf

SEC Declines to Approve Two Exchanges' Rules Authorizing Nine Bitcoin Futures ETPs:

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of August 25, 2018. 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 other employees.

©2019 Katten Muchin Rosenman LLP

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About this Author

Gary DeWaal, Securities Attorney, Katten Law Firm, New York
Special Counsel

Gary DeWaal focuses his practice on financial services regulatory matters. He counsels clients on the application of evolving regulatory requirements to existing businesses and structuring more effective compliance programs, as well as assists in defending and resolving regulatory disciplinary actions and enforcement matters. Gary also advises buy-side and sell-side clients, as well as trading facilities and clearing houses, on the developing laws and regulations related to cryptocurrencies and digital tokens.

Previously, Gary was a senior...

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