June 21, 2021

Volume XI, Number 172

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June 18, 2021

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Bridging the Week: Dec 5 to 9 and Dec 12, 2016 (Position Limits; Aggregation; Owned Entity Exemption; Insider Trader; Manipulation)

Last week, the Commodity Futures Trading Commission proposed revised position limit rules and finalized requirements related to the aggregation of positions and accounts to assess compliance with speculative position limits as well as to add a potential exemption to such requirements for entities within a group that trade independently of each other and have procedures and controls to ensure such independence. In addition, the United States Supreme Court found a sufficient basis to uphold the conviction of a tippee accused of trading on inside information he indirectly received from a corporate insider, while a federal court in New York rigorously questioned Commodity Futures Trading Commission attorneys during their closing arguments about the function of markets in a case where the agency had alleged manipulation and attempted manipulation by a trader. As a result, the following matters are covered in this week’s edition of Bridging the Week:

  • CFTC Adopts Final Rules Related to Aggregation of Positions and Owned Entity Exemption; Re-Proposes Position Limits Rules;

  • Supreme Court Rules Sharing of Nonpublic Information With Relative Is Sufficient to Find Illegal Insider Trading in Tipper/Tippee Context (includes Legal Weeds);

  • Judge Questions CFTC’s Theory of Markets in DRW Alleged Manipulation Case During Closing Arguments;

  • Company Settles With SEC for Transacting in OTC Pre-IPO Security-Based Swaps Contracts With Non-Eligible Contract Participants;

  • ICE Futures Criticized in CFTC Rule Review for Not Completing Investigations in One Year or Less (includes My View);

  • International Swap Dealer Settles With CFTC for Alleged Failure to Timely Report Certain OTC Swaps (includes Compliance Weeds);

  • Broker-Dealer Agrees to Pay US $16.5 Million to Resolve FINRA Charges That It Had Deficient AML Program (includes Compliance Weeds);

  • Political Update: The Potential New CFTC Chair Suggesteth and the Current CFTC Chair Revieweth; and more.

Briefly:

  • CFTC Adopts Final Rules Related to Aggregation of Positions and Owned Entity Exemption; Re-Proposes Position Limits Rules: On December 5, the Commodity Futures Trading Commission issued final regulations regarding the aggregation of commodity derivatives positions for assessing compliance with CFTC position limits requirements, and re-proposed regulations regarding position limits. These rules were initially proposed in 2011 and then again in 2013 and subject to two supplemental proposals since. In order to assess a person’s compliance with applicable speculative position limits, the CFTC’s new aggregation rules would require the person to aggregate all futures and related options positions (on a futures equivalent basis) and accounts in which the person directly or indirectly controls trading with (1) all positions and accounts in which the person holds a 10 percent or more ownership or equity interest and (2) the positions of any other person with which the person trades pursuant to an express or implied agreement, absent an exemption. These requirements are generally consistent with an existing requirement (click here to access CFTC Rule 150.4) and CFTC policy. However, the CFTC’s new aggregation rules contain a new potential authority for entities within a group that trade independently of each other and have procedures and controls to ensure such independence to disaggregate positions. Separately, the CFTC re-proposed its position limits rules. Compared to its 2013 proposed rules, the Commission’s newly re-proposed requirements: (1) reduce the number of core agricultural, energy and metals futures contracts and their economically equivalent futures, options and swaps (collectively, “referenced contracts”) subject to express oversight by the Commission for position limits purposes (as opposed to exchanges) from 28 to 25; (2) revise spot month, single and all-months positions limits on the 25 referenced contracts; (3) define bona fide hedging to more closely parallel the definition in applicable law (click here to access Sec. 4a of the Commodity Exchange Act, 7 USC § 6a); and authorize persons to apply for non-enumerated hedging exemptions from qualified exchanges even for referenced contracts. The final aggregation rules are scheduled to be effective 60 days after their publication in the Federal Register, during which time the CFTC will accept comments on the proposed position limit rules. 

  • Supreme Court Rules Sharing of Nonpublic Information With Relative Is Sufficient to Find Illegal Insider Trading in Tipper/Tippee Context: The United States Supreme Court upheld the conviction of Bassam Salman, who traded profitably on nonpublic information received from a friend, Mounir Kara (who himself had received the information from the friend’s younger brother, Maher Kara) based on a theory of trading on prohibited insider information. At the relevant time, Maher was an investment banker in Citigroup’s healthcare investment banking group, where he was privy to confidential information that he had a duty not to disclose, observed the Supreme Court. Generally, said the Supreme Court, an individual who receives so-called “inside information” – termed a “tippee” – from a person who has a fiduciary duty not to disclose such information – termed a “tipper” – breaches his/her fiduciary duty if the tipper receives a “personal benefit.” (Click here to access the Supreme Court’s decision in Dirks v. SEC.) Because of his alleged trading on insider information and his knowledge of the source and circumstances of such information, Mr. Salman was criminally charged for violating the relevant securities law and regulation of the Securities and Exchange Commission that prohibit trading on inside information; convicted; sentenced to three years imprisonment; and required to make over US $730,000 in restitution. (Click here to access the relevant law, 15 USC § 78j(b) and here to access SEC Regulation 10b-5, 17 CFR §240.10b-5.) Mr. Salman appealed his conviction to a federal court of appeals in California. While Mr. Salman’s appeal was pending, a federal court of appeals in New York reversed the conviction of two portfolio managers who traded on insider information received indirectly through two remote corporate insiders, saying that the distance between the managers and the insiders was too great to demonstrate that the managers knew the insiders initially exchanged their information in breach of a duty. The New York court acknowledged that a factfinder could infer a personal gift to a tipper from the gift of confidential information to a trading relative or friend – based on Supreme Court’s decision in Dirks – but that such inference was impermissible absent proof “of a meaningfully close personal relationship that generates an exchange that is objective, consequential and represents at least a potential gain of a pecuniary or similarly valuable nature.” Notwithstanding the NY federal court’s decision, the California federal court of appeals upheld Mr. Salman’s conviction. In affirming the California court’s decision, the Supreme Court concluded that it was “obvious” that Maher received a personal benefit from providing inside information to his brother as he expected his brother to trade on it. This is because, said the Supreme Court, giving a gift of trading information “is the same thing as trading by the tipper followed by a gift of the proceeds.”

Legal Weeds: The same provisions of the applicable securities law and SEC rule that serve as the basis for a civil action or criminal prosecution for inside trading of securities is the inspiration for a similar provision under law that prohibits employment of a manipulative or deceptive device or contrivance in connection with futures or swaps trading. (Click here to access Commodity Exchange Act Section 6(c)(1), US Code § 9(1), and here to access CFTC Rule 180.1.) The CFTC has previously brought two actions that sound in the securities law concept of inside trading for an employee impermissibly trading based on futures positions of his employer.

  • Judge Questions CFTC’s Theory of Markets in DRW Alleged Manipulation Case During Closing Arguments: The US federal district court judge hearing the alleged manipulation case against Donald Wilson and DRW Investments LLC brought by the Commodity Futures Trading Commission in 2013 constantly interrupted closing arguments by CFTC attorneys to try to better understand why, if, as alleged, the defendants were constantly bidding prices that were artificially high, no sellers hit their bids to take advantage of the artificially high prices. In its initial complaint the CFTC had charged the defendants with manipulating and attempting to manipulate the settlement prices of the IDEX USD Three-Month Interest Rate Swap Futures Contract listed on the NASDAQ OMX Futures Exchange and cleared by the International Derivatives Clearing House at various times from January through August 2011. According to the Commission, DRW established a long position in the Three-Month Contract beginning in August 2010. Afterwards, beginning in December 2010, the defendants placed bids “that DRW knew would never be accepted” artificially to influence the settlement prices in their favor during the 15-minute period that most influenced settlement prices on at least 118 trading days, in a “banging the close”–type scheme, charged the CFTC. According to Commission attorneys during their closing arguments, it was the intent of defendants to produce a “price distortion” through placement of “illegitimate bids during the closing period day after day for seven straight months” that favored defendants’ existing positions (by prompting favorable settlement prices) that resulted in “a price distortion.” Among other things, said the Commission staff, defendants’ bids were illegitimate because they knew there was no market interest on the other side. However, during the Commission’s closing arguments, the Hon. Richard J. Sullivan, the judge hearing the case, repeatedly interrupted and questioned the CFTC’s attorneys to better understand why defendants’ bids were illegitimate and the settlement prices that derived from defendants’ bids were artificial. According to the court, “if you are bidding here and nobody is taking in an efficient and rational market, that’s because your bids are too low and you better raise them and somebody might bite the more you raise it. Isn’t the fair inference that these bids were not artificial or, if they were artificial, they are artificially low?” Moreover, said the judge, “[w]hat is the rule that the CFTC wants to adopt here? If you are not getting hits after … two months, you can’t make bids anymore or you can’t make them in the settlement period because they will affect your open positions and we’re going after you if that’s the case?” A different judge previously ruled in this case that the CFTC had to prove that defendants had “the specific intent to affect market prices that ‘did not reflect the legitimate forces of supply and demand’” in connection with its enforcement action against the defendants alleging manipulation and attempted manipulation. (Click here for details.) Post-trial briefs by by CFTC and the Defendants are due in the current action by December 21; a decision will be rendered by the judge afterwards.

  • Company Settles With SEC for Transacting in OTC Pre-IPO Security-Based Swaps Contracts With Non-Eligible Contract Participants: Equidate, Inc. and Equidate Holdings LLC agreed to settle charges with the Securities and Exchange Commission that, from August 2014 through December 2015, it offered and sold security-based swaps with persons who did not qualify as eligible contract participant. (ECPs constitute several types of highly sophisticated or financially qualified persons. Click here to access a definition at 7 USC § 1a(18).) Under applicable law, security-based swaps may only be offered and sold to retail persons that are subject to an effective registration statement and if the transaction is effected on a national securities exchange. (Click here to access 15 USC § 77e(e) and here for 15 USC § 78(f)(l).) According to the SEC, Equidate, with its wholly owned subsidiary, Equidate Holdings, provided an electronic marketplace for employees and shareholders of privately held companies and investors seeking to invest in the potential economic return in the shares of those companies. The contracts offered by Equidate included payment provisions that were triggered by certain events, such as a merger or acquisition or initial public offering at an underlying company. Typically, the contracts were designed to transfer the potential economic return of reference shares from an employee or shareholder to the investor through the respondents. Although Equidate maintained a website that obtained background information on investors, it did not determine whether they were ECPs. According to the SEC, Equidate expressly sought legal advice regarding whether its contracts would be considered swaps and was advised they would not. Respondents agreed to cease and desist from further violations of applicable and to pay a fine of US $80,000 to resolve the SEC’s charges.

  • ICE Futures Criticized in CFTC Rule Review for Not Completing Investigations in One Year or Less: The Commodity Futures Trading Commission criticized ICE Futures U.S. for not completing investigations in one year or less absent mitigating circumstances, as required by its rules, in a rule enforcement review of the exchange's trade surveillance program. In addition, the CFTC recommended that ICE Futures better document its trade practice reviews to evidence, among other things, the trade dates reviewed; retain or have the capability to replicate parameters utilized to generate exception reports that prompt trade practice reviews; and expand trade practice reviews, as appropriate, to look for patterns of abuse by looking at additional trading days other than those initially flagged.

My View: In the CFTC’s rule review of ICE Futures, it noted that the Market Regulation department of the exchange has the authority to issue warning letters or a summary fine of up to US $10,000 if it determines that a rule violation may have occurred but is viewed to be minor. The CFTC noted that the exchange issued warning letters to 29 respondents based on trade practice investigations during the target period of its review. It raised no issued with such letters. This approach contrasts with the position taken by CFTC staff in a recent rule review of the CBOE Futures Exchange, LLC. There, the CFTC recommended that the exchange should promptly take appropriate disciplinary action when it makes a finding that a violation of a substantive trading rule occurred. This may sound innocuous; however, the recommendation was made in response to the issuance of warning letters by CFE to certain trading permit holders in response to their alleged placement of fictitious orders and trades. According to CFTC staff, “[w]hile a warning letter may be appropriate for certain violations of recordkeeping or audit trail rules, the Division believes that issuing a warning letter for a substantive trading violation is never appropriate.” (Click here for details regarding the rule review and findings.) As I wrote in September, this statement appears contrary to existing CFTC rules, and potentially limits the flexibility of exchange staff to deploy investigative and enforcement resources in the most efficient manner they determine. It’s good if the CFTC is backing off its earlier erroneous view.

  • International Swap Dealer Settles With CFTC for Alleged Failure to Timely Report Certain OTC Swaps: Société Générale agreed to pay a fine of US $450,000 to settle charges brought by the Commodity Futures Trading Commission that, from July 2014 through April 2015, it failed to timely report transaction information regarding certain of its FX swaps, FX forwards and non-deliverable forwards to a registered swap data repository, as required by the CFTC. During the relevant time, Société Générale was a provisionally registered swap dealer with the CFTC. According to the Commission, in January 2015, Société Générale recognized on its own that, because of a coding error, its computer system improperly flagged the counterparty as the reporting party for a swap transaction in all circumstances. As a result, neither party, during the relevant time, made required reports of such transactions to an SDR, including the requisite continuation data. The bank promptly began to fix the error that was resolved by April 2015. Subsequently, the bank back-loaded its missed reports. In settling with Société Générale, the CFTC expressly recognized the bank’s “significant cooperation” during the investigation that included “self-reporting, undertaking an internal investigation and taking remedial steps to correct its reporting failures.”

Compliance Weeds: Previously, staff of the Commission’s Division of Swap Dealer and Intermediary Oversight published a Staff Advisory reminding swap dealers and major swap participants of their obligations to report certain swap data timely and accurately (click here to access). Staff noted “diverse reporting issues and failure,” with certain types of errors occurring “with some frequency”; readily apparent errors; incomplete reporting; duplicative swap reporting; calculation errors; and reporting delays. Staff recommended utilizing certain measures or processes to enhance reporting quality; data gatekeepers; automated review of reported data; erroneous record checks; and improved changed management practices to help mitigate potential issues. Staff also reminded SDs and MSPs that if they utilize third-party service providers to report swap data, they still remain “responsible” for complying with applicable requirements. As a result, SDs and MSPs should be routinely monitoring the accuracy and timeliness of their data reporting. Staff’s warning at the end of their advisory sounds ominous: “this advisory should not be construed in any way as excusing past violations or limiting the CFTC’s ability to pursue any actions for reporting violations.” In addition to this current matter against Société Générale, the CFTC previously filed and settled charges against other swap dealers, including Deutsche Bank AG. As a result of charges against Deutsche Bank in 2015, the bank agreed to pay a fine of US $2.5 million and to enhance controls around its swaps reporting. (Click here for more information.) More recently, the bank was sued a second time by the CFTC for alleged recidivist reporting violations; the parties have agreed to resolve that matter too. (Click here for more information.)

  • Broker-Dealer Agrees to Pay US $16.5 Million to Resolve FINRA Charges That It Had Deficient AML Program: Credit Suisse Securities (USA) LLC agreed to pay a fine of US $16.5 million to the Financial Industry Regulatory Authority for alleged breakdowns in its anti-money laundering program from January 2011 through December 2015. According to FINRA, from January 2011 through September 30, 2013, the firm failed to “effectively review trading from an AML standpoint.” This is because, said FINRA, during this relevant time, the firm principally relied on its registered representatives to identify and report to the firm’s AML Compliance department activity or transactions that were unusual or suspicious based on red flags highlighted in the firm’s AML policies. However, alleged FINRA, these policies were not “effective” because there were gaps in the review of potentially suspicious or unusual trading and, during the relevant time, certain potentially problematic trading occurred – such as certain microcap stock transactions and sales of unregistered securities – that was not escalated to AML Compliance to assess whether the firm should file a required suspicious activity report. Also, claimed FINRA, during the entire relevant time, Credit Suisse relied on an automated surveillance system to monitor client activity for potentially suspicious money and securities transfers using certain scenarios that the firm determined to implement. However, in fact, the firm failed to implement the scenarios Credit Suisse determined to use or other scenarios that were designed to identify certain “common” suspicious patterns or activities, alleged FINRA. Moreover, said FINRA, Credit Suisse failed to ensure that data fed into its surveillance system was complete (it was not) and failed always to adequately review and investigate identified problematic activity. FINRA claimed that the firm did not have sufficient staffing to review the number of alerts its automated system generated.

Compliance Weeds: Recently, the Financial Crimes Enforcement Network of the US Department of Treasury issued an advisory stating that covered financial institutions must file a suspicious activity report following certain cyber-events (click here for details). Mandatorily reportable incidents are those where a financial institution is targeted by a cyber-event where it knows, or has reason to suspect, the event “was intended, in whole or in part, to conduct, facilitate, or affect a transaction or series of transactions” that involves or aggregates or could involve or aggregate to US $5,000 or more in funds or other assets. It would not matter whether the transaction or series of transactions ended up actually occurring. In addition, FinCEN indicated that it encourages but does not require SAR filings when a financial institution sustains “egregious, significant or damaging cyber-events” that may not require mandatory reporting. An example of this would be a barrage of messages aimed at a financial institution (known as a “DDoS attack”) that damages its website and prevents customers from accessing their accounts for a prolonged period of time. Covered financial institutions include banks, broker-dealers, future commission merchants, introducing brokers and mutual funds

And more briefly:

  • CME Group Enhances Audit Trail for Internally Developed Average Price Systems: CME Group proposed to amend its rules to require exchange clearing member firms that internally calculate average prices to transmit those prices and ultimate customer account allocations back to CME Clearing. Moreover, CME Group proposed to require that customers request average pricing before placing an order. CME Group self-certified its proposals (i.e., making them normally effective after 10 business days absent Commission objection), but indicated that its amendments would not be effective until July 31, 2017. CME Group proposed similar amendments on February 4, 2016, but withdrew them a few days later for discussions regarding technological issues that could have precluded clearing members’ compliance.

  • FCA Seeks Comments on Conduct of Business Rules for Firms Offering Contracts for Differences to Retail Clients, Including Rolling Spot FX Products: The UK Financial Conduct Authority issued a consultation paper seeking views on proposed measures to limit the risks of contract for difference products offered and sold to retail investors. (CFDs – which are popular financial instruments for UK retail investors – are financially settled instruments often offered through online platforms that permit investors to gain indirect exposure to the price movements in an underlying index, single stock equity, commodities or FX pairs. CFDs include leveraged rolling spot foreign exchange products.) Among other things, FCA proposed to introduce standardized risk warnings and mandatory disclosure of profit and loss ratios; setting lower leverage limits for inexperienced clients with less than 12 months’ experience (25:1) and capping leverage limits for all retail clients (50:1); and preclude offering trading or account opening bonuses to retail investors to promote CFD products. Comments will be accepted by the FCA on its proposals through March 7, 2017.

Political Update:

  • The Potential New CFTC Chair Suggesteth and the Current CFTC Chair Revieweth: During a speech last week before ISDA’s Trade Execution Legal Forum, Commissioner J. Christopher Giancarlo gave a preview of some of his potential actions if he becomes Acting Chairman of the Commodity Futures Trading Commission, as expected, on or before the inauguration of President-elect Donald Trump. Regarding recently re-proposed Regulation Automated Trading, Mr. Giancarlo reiterated his opposition to provisions requiring production of source code without a subpoena as well as concerns with some of the “prescriptive risk controls, and development, testing and reporting requirements” that he considers not reflective of industry best practices. Notwithstanding, he said he was open to a number of the proposed rules elements. According to Mr. Giancarlo, “[i]it is certainly time to formulate and establish well-considered policy responses to the digitization of contemporary markets and then take action in a deliberate and through manner to enhance market liquidity, safety and soundness.” In the same speech, Mr. Giancarlo again criticized the CFTC’s swaps trading regulatory framework and the negative impact he perceives it has had on liquidity in global swaps markets. Mr. Giancarlo says that liquidity has been fractured between “an on-[Swap Execution Facility], US person market on one side and an off-SEF, non-U.S. person market on the other.” According to Mr. Giancarlo, “[t]he time has come for the CFTC to revisit its flawed swaps trading rules to better align them to market dynamics, allow U.S. swap intermediaries to fairly compete in world markets and reverse the tide of global market fragmentation.” Also last week, in voting to issue the re-proposed regulations regarding position limits, Mr. Giancarlo noted that he had “always been open to supporting a well-conceived and practical position limits rule that restricts excessive speculation.” Although he suggested there was more refinement that needed to be undertaken to the proposed rules, he indicated that the CFTC’s current re-proposed requirements “provide the basis for the implementation of a final position limits rule that I could support.” In speeches last week, Timothy Massad, the current CFTC chairman, discussed the benefits of mandatory clearing by noting the resilience of the clearing system during recent market volatility precipitated by the UK Brexit vote and warning that “eliminating essential derivatives reforms would be a big step backward.” He also urged continued attention to concerns raised by automated trading.

©2021 Katten Muchin Rosenman LLPNational Law Review, Volume VI, Number 347
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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...

212-940-6558
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