Bridging the Week: February 29 – March 4, and 7, 2016 (Electricity; Prearranged Trades; Delivery Line Freshening; FCPA; Limiting Bank Exposure)
Monday, March 7, 2016

Last week, a federal court in California refused to stop the Federal Energy Regulatory Commission from seeking to affirm its July 2013 order that a bank and four of its traders manipulated electricity prices from 2006 to 2008 to benefit the bank’s swap positions, while the Securities and Exchange Commission settled charges with a company, claiming the firm’s hiring of relatives of Chinese government officials constituted violations of the Foreign Corrupt Practices Act. In addition the Board of Governors of the Federal Reserve System proposed rules to limit the credit exposure of big banks to any single counterparty. As a result, the following matters are covered in this week’s edition of Bridging the Week:

  • California Federal Court Refuses to Stop FERC Lawsuit to Uphold the Validity of US $453 Million Penalty for Manipulating Electricity Prices (includes Legal Weeds);

  • All in the Family Prearranged Trades Result in CME Group Fines; Delivery Line Freshening Transactions Also Result in Sanctions (includes Compliance and Legal Weeds);

  • US Company Fined US $7.5 Million by SEC for Hiring Relatives of Chinese Government Officials to Obtain Business (includes Compliance Weeds);

  • Fed Proposes Rules to Reduce Credit Exposure of Large Banking Organizations to Single Counterparty;

  • Broker-Dealer Penalized by FINRA for Inadequately Monitoring Registered Representatives’ Tax Garnishments That Might Require a Registration Filing Update (includes Compliance Weeds);

  • Introducing Broker Permanently Barred as NFA Member for Solicitation Practices; Principal and Certain APs Also Sanctioned;

  • Totally Irrelevant (But Is It): Reflections on the Article, “A Eulogy for the Pit Trader: An Oral History of Chicago’s Commodity Futures Pits” by John McDermott; and more.

Video Version:

Briefly:

  • California Federal Court Refuses to Stop FERC Lawsuit to Uphold the Validity of US $453 Million Penalty for Manipulating Electricity Prices: A federal court in California refused to stop a lawsuit by the Federal Energy Regulatory Commission against Barclays Bank PLC and four of its traders to affirm FERC’s July 2013 order requiring the defendants to pay US $453 million in civil penalties for their alleged manipulation of electricity prices in California and other western markets between November 2006 and December 2008. The defendants had requested a stay of FERC’s lawsuit after their motion for limited discovery was denied in December 2015 and they filed a notice of appeal. In ruling against the defendants’ stay request, the court said that nothing precluded the defendants from arguing during the affirmation hearing that FERC’s “motion to affirm must be denied because the submitted record is deficient.” Moreover, said the court, “[a]closer look at what evidence has been submitted to this Court, and what process was afforded Defendants during the investigation phase, will aid a determination as to whether discovery is required and its scope, and whether different fact-finding must take place in this Court.” In its July 2013 order, FERC found that Barclays, Daniel Brin, Scott Connelly, Karen Levine and Ryan Smith engaged in a manipulative scheme when, on numerous occasions during the relevant time period, they traded electricity to increase or decrease the value of an electricity index in order to benefit swap positions held by the bank based on the index. In addition to civil penalties, the FERC’s July 2013 order required Barclays to disgorge US $34.9 million in alleged profits and interest.

Legal Weeds: The current litigation by FERC follows a somewhat unique process in which FERC first required the defendants to answer allegations that they manipulated western electricity markets. The defendants exercised their right not to respond. This permitted FERC to assess a penalty on its own without a hearing before an administrative law judge. Once the penalty was assessed and the defendants did not pay, FERC was entitled to seek affirmation of the penalties from a federal district court. Effectively, this process grants defendants a right to challenge FERC’s allegations in a federal court as opposed to before an administrative tribunal. (Click here for a schematic of FERC’s penalty assessment process.)

  • All in the Family Prearranged Trades Result in CME Group Fines; Delivery Line Freshening Transactions Also Result in Sanctions: A hearing committee of the Chicago Mercantile Exchange held that Aaron Wilkey and Melissa Wilkey, husband and wife, violated exchange rules when, on multiple occasions between December 2012 and April 2013, they entered into futures transactions to transfer equity from accounts controlled by Mr. Wilkey to an account controlled by Ms. Wilkey. Some of the trades were supposedly executed non-competitively on Globex, while others were allegedly done in the open market. Mr. Wilkey was also found to have engaged in 42 prearranged transactions from June 1, 2011, to August 31, 2011, to transfer equity from his mother’s account to his wife’s account. As sanctions, Mr. and Ms. Wilkey were each permanently barred from trading CME Group products and ordered to pay a US $100,000 fine and, jointly and severally, to pay US $23,000 in restitution and US $40,925 in disgorgement. Separately, Case Gabel and Zachary May each agreed to pay a fine of US $30,000 and be suspended from trading CME Group products for five days to resolve charges brought by CME that, on multiple occasions in 2012, they matched buy and sell orders for Live Cattle futures contracts for accounts with common beneficial ownership to freshen delivery dates.

Compliance Weeds: For products settling by physical delivery against the oldest open long position (e.g., Live Cattle futures contracts), both the CBOT and CME permit the liquidation and re-establishment of futures positions intraday to defer physical delivery. However, relevant trades for a single account or accounts with common beneficial ownership must be competitively executed and must be independent transactions subject to market risk. CME Group will regard pre-arranged purchases and sales or buys and sells executed as part of an express or implied agreement for a single account or accounts with common beneficial ownership to constitute prohibited wash trades. (Click here to access CME Group Market Regulation Advisory Notice RA1411-5RR (January 6, 2015), question and answer 8.)

Legal Weeds: In the relatively early days of the Commodity Futures Trading Commission, the CFTC sought to ban the practice of freshening positions to defer delivery through an enforcement action against Manning Stoller, who had engaged in such practice to avoid taking delivery of potatoes on his New York Mercantile Exchange futures contracts in May 1976. He did this because he believed potato prices were artificially depressed. However, this marked the first time that the CFTC, or its predecessor agency, the Commodity Exchange Authority, had formally suggested that freshening –a then common industry practice– constituted prohibited wash sales. Ultimately the US Court of Appeals in New York held that, although the CFTC could take this position, it could not do so for the first time in an enforcement action against defendant. According to the court, “if the Commission suddenly changes its view …with respect to what transactions are ‘bona fide trading transactions,’ it may not charge a knowing violation of that revised standard and thereby cause undue prejudice to a litigant who may have relied on the agency's prior policy or interpretation.” (Click here to access the decision in Stoller v. Commodity Futures Trading Commission, 834 F2d 262 (2d Cir 1987).)

  • US Company Fined US $7.5 Million by SEC for Hiring Relatives of Chinese Government Officials to Obtain Business: Qualcomm Incorporated agreed to pay a fine of US $7.5 million to the Securities and Exchange Commission to resolve charges that, from 2002 through 2012, it provided “things of value” to foreign officials to encourage use of the company’s technology in China, in violation of the Foreign Corrupt Practices Act. According to the SEC, during this time, Qualcomm hired three relatives of officers of state-owned enterprises in China and provided other benefits, including frequent meals, gifts and entertainment, to foreign officials and their family members in order to gain a business advantage. Qualcomm is an issuer of SEC-registered securities that designs and sells wireless telecommunication products. Under the FCPA, no issuer of SEC-registered securities may give “anything of value to any foreign official for the purposes of influencing the official or inducing the official … to induce a foreign official to use his influence with a foreign governmental instrumentality to influence any act or decision of such government or instrumentality” (emphasis added). Last year, The Bank of New York Mellon Corporation also agreed to pay sanctions of almost US $15 million to resolve SEC allegations that its retention of three interns during 2010 and 2011 constituted FCPA violations. The SEC claimed that, in order to maintain and expand business with an unidentified Middle Eastern sovereign wealth fund, BNY agreed to retain three family members of two government officials who were both senior officials affiliated with the sovereign wealth fund. None of the interns, claimed the SEC, met the “rigorous criteria” of the internship program ordinarily administered by BNY.

Compliance Weeds: Firms conducting business abroad often struggle with how to adhere to local custom that incorporates gift giving as a means to demonstrate respect and collegiality while at the same time complying with the strict prohibitions imposed by the FCPA. Unfortunately, under the FCPA, there is not a threshold that provides a safe harbor for gift giving or any other payment (whether in cash or in kind) if the intent is to improperly influence a government official. However, staff of the US Department of Justice and the SEC have jointly published a helpful guide that notes that “[i]tems of nominal value, such as cab fare, reasonable meals and entertainment expenses, or company promotional items, are unlikely to improperly influence an official, and, as a result, are not, without more, items that have resulted in enforcement action by DOJ or SEC.” It’s not a bright line test, but it’s something. Also keep in mind, the FCPA applies not only to issuers of SEC-registered securities, but also all US “domestic concerns” (e.g., all US citizens, nationals, residents and incorporated entities) and certain foreign nationals or entities too. (Click here to access A Resource Guide to the U.S. Foreign Corrupt Practices Act by staff of the DOJ and SEC.)

  • Fed Proposes Rules to Reduce Credit Exposure of Large Banking Organizations to Single Counterparty: The Board of Governors of the Federal Reserve System proposed rules to minimize the credit exposure of large banking organizations to a single organization. Generally, under the proposed rules, a globally systemically important bank (GSIB) would be prohibited from maintaining a credit exposure of more than 15% of its Tier 1 capital with another systemically important financial firm and more than 25% of its Tier 1 capital with any other counterparty. (Tier 1 capital is the core capital of a bank typically consisting of its shareholder equity and retained earnings; it might include certain preferred stock.) Banks, other than GSIBs, with US $250 billion or more of assets would be limited to a credit exposure to any single counterparty of no more than 25% of their Tier 1 capital, while banks holding between US $50 billion and US $250 billion in assets could have no more than 25% of their total regulatory capital (a broader base than Tier 1 capital) exposed to any single counterparty. Banks with less that US $50 billion in assets would not have counterparty exposure limits under the proposed rules. In assessing credit exposure, covered entities would consider their aggregate net exposure with a counterparty, taking into account any available credit offsets including collateral, guarantees, credit or equity derivatives or other hedges, provided the offsets satisfied certain requirements. Credit exposure would consider to arise from a number of enumerated type of credit transactions, including (among others) all extensions of credit, repurchase or reverse repurchase transactions, securities lending transaction and derivatives transactions. In assessing credit exposure under derivatives transactions, different rules would apply to derivatives transactions subject and not subject to a qualifying master netting agreement. Derivatives transactions subject to a qualifying master netting agreement could potentially be accorded more favorable treatment. The FRB previously proposed rules restricting counterparty credit exposures for banks in December 2011. The FRB will accept comments on its proposed new rules through June 3, 2016.

  • Broker-Dealer Penalized by FINRA for Inadequately Monitoring Registered Representatives’ Tax Garnishments That Might Require a Registration Filing Update: A broker-dealer agreed to pay a fine of US $300,000 to resolve charges brought by the Financial Industry Regulatory Authority that it did not amend or timely amend information on file with FINRA for its registered representatives to report unsatisfied tax liens and civil judgments. The updating was required by FINRA rules. According to FINRA, from January 1, 2013, through June 30, 2015, the broker-dealer received 71 wage garnishment orders from courts and tax authorities for 57 registered representatives. FINRA claimed the firm did not consistently investigate whether these orders would necessitate amending the individuals’ registration application on Form U4 to disclose unsatisfied liens and judgments. As a result, said FINRA, in 41 instances, amended Form U4s were not timely filed or filed at all, as required. Last year another broker-dealer also agreed to pay a fine of US $500,000 to FINRA for its alleged failure to update its individual registrants’ personal information to disclose unsatisfied tax liens and judgments where it had been provided garnishment notices regarding such individuals. In that matter, FINRA also charged that, during the relevant time, the firm received wage garnishment orders from courts and tax authorities but did not have a procedure to determine whether the underlying event involved an event that required an update of the relevant individual’s registration information.

Compliance Weeds: Registration and membership applications with regulators cannot be forgotten once filed. Most applications, like Form U4 or National Futures Association Form 8R, place an affirmative obligation on individuals to amend and update information requiring disclosure promptly after a change occurs. FINRA has not hesitated to bring disciplinary actions against a broker-dealer where, in its judgment, the firm was on notice that its registrants’ disclosure information should have been updated but was not. (Click here for instructions to Form U4 and here for instructions to Form 8R describing this ongoing obligation.)

  • Introducing Broker Permanently Barred as NFA Member for Solicitation Practices; Principal and Certain APs Also Sanctioned: Portfolio Managers, Inc., an introducing broker registered with the Commodity Futures Trading Commission and a member of the National Futures Association, and Amanda Murphy, the firm’s principal, agreed to settle charges brought by NFA that the firm engaged in misleading, deceptive and high-pressure sales techniques through associated persons in its Los Angeles branch office, in violation of NFA rules. Christopher Hogan, Thomas Heneghan and Andrew Zhukov, the relevant LA-based APs, were also named in NFA’s charges. However, as the three LA-based defendants did not answer NFA’s complaint, an NFA business conduct committee concluded they were deemed to have admitted all of NFA’s legal conclusions of wrongdoing. As a result, the BCC permanently barred Mr. Hogan and Mr. Heneghan from any association with an NFA member, but barred Mr. Zhukov for only three years, saying his conduct was less egregious. NFA filed its complaint against the defendants after its examination of PMI’s LA branch office found that, between October 2012 and August 2015, 66 of 68 customers lost money trading options through PMI, totaling approximately US $1.2 million, including over US $660,000 in commissions. NFA also said that Ms. Murphy received multiple “extremely serious customer complaints” against Mr. Heneghan alleging that he had stolen customer funds. However, she never disclosed the complaints to NFA even when she was aware that NFA was actively investigating him, said NFA.

And more briefly:

  • FINRA Proposes to Shorten the Securities Settlement Cycle by One Day: The Financial Industry Regulatory Authority seeks comment on a proposal to conform its rules to accommodate the expected reduction in the settlement cycle for equities, municipal and corporate securities, and certain securities by three days after trade date to two days. The Securities and Exchange Commission is currently developing a proposal to shorten the settlement cycle, to be implemented by the third quarter of 2017. FINRA will accept comments on its proposal through April 4, 2016.

  • FinCEN Reports an 812% Increase in Reported Instances of Suspicious Activity Attributable to Layering From 2012/13 Through 2014: The Financial Crimes Enforcement Network recently published statistics regarding reports of suspicious activities filed with it. According to FinCEN, the suspicious activity categories prompting the largest increase in filings from 2012-2013 to 2014 by securities and futures firms were unauthorized wire transfers and email compromise (including email hacking and phishing). The number of SARs referencing prearranged trading decreased during the time period from 217 to 182.

  • Former Trader Who Pleaded Guilty to Playing a Role in the Manipulation of LIBOR Barred From Business by FCA: Michael Curtler, a former employee of Deutsche Bank AG, was permanently barred from associating with any entity regulated by the Financial Conduct Authority for his role in the manipulation of the London Interbank Offered Rate for US Dollar from January 2003 to 2011. In October 2015, Mr. Curtler pleaded guilty before a federal court in New York to conspiracy to commit wire fraud and bank fraud in connection with the manipulation.

  • ASIC Files Charges Against Bank for Role in Setting Australia’s Primary Interest Rate Benchmark: The Australian Securities and Investments Commission filed charges against the Australia and New Zealand Banking Group Limited, claiming it engaged in manipulative conduct in connection with its role in setting the bank bill swap reference rate (BBSW) on 44 days from March 2010 to May 2012. The BBSW is Australia’s benchmark interest rate. ASIC is seeking monetary damages and implementation of a compliance program by ANZ.

  • Japanese Regulator Recommends Fine Against Asset Manager for Market Manipulation: The Securities and Exchange Surveillance Commission of Japan recommended to Japan’s Financial Services Agency that a fine of JY 7.4 million (approximately US $36,000) be imposed against Blue Sky Capital Management Pty Ltd for engaging in trading in a single stock on the Tokyo Stock Exchange on June 17, 2014, to mislead other traders to believe there was active trading in the stock, when there was not. Blue Sky is an asset manager based in Australia.

  • NFA Updates Regulatory Requirements and Self-Examination Questionnaire for FCMs, FDMs, IBs, CTAs and CPOs to Reflect New Cybersecurity Expectations: The National Futures Association has updated its Regulatory Requirements brochure and Self-Examination Questionnaire for futures commission merchants, forex dealer members, introducing brokers, commodity pool operators and commodity trading advisors to reflect new requirements of members related to cybersecurity as of March 1, 2016. Under NFA rules, members must review their operations at least annually using NFA’s Self-Examination Questionnaire and ensure an appropriate supervisor sign and date an attestation.

  • Basel Committee Proposes New Operational Risk Framework: The Basel Committee on Banking Supervision issued proposed revisions to its operational risk capital framework for banks. Under its proposal, three existing standardized approaches and an advance measurement approach be eliminated, and replaced by a new standardized measurement approach. The new measure would compare a bank’s operational risk exposure as derived by items on its profit and loss statement with a firm’s individual past operational losses. Comments will be accepted through June 3, 2016.

And finally:

  • Totally Irrelevant (But Is It): Reflections on the Article, “A Eulogy for the Pit Trader: An Oral History of Chicago’s Commodity Futures Pits” by John McDermott: For those of us who entered the exchange-traded derivatives industry before today’s algorithmic trading systems were ever contemplated, John McDermott’s article “A Eulogy for the Pit Trader” in the current edition of MEL (click here to access) provides a nostalgic look back at the days when a futures market constituted hundreds of persons standing side by side (or maybe on top of each others’ toes) in trading pits (or rings if you were in New York) screaming and hollering their bids and offers, surrounded by a cacophony of clerks, runners, telephone cords, trading booths and an avalanche of paper. I personally prefer to watch the film Trading Places for the umpteenth time when I want to recollect the wonderfully chaotic days of active floor trading (which I did most recently just three weeks ago). However, Mr. McDermott’s brief article provides insight into five individuals’ (including one woman’s) experiences as Chicago-based floor brokers before and after the turn of this century, describing their entry into the profession, some of their most memorable experiences on the floor and their thoughts on the demise of an important historical institution. It’s just an appetizer at best, but it’s still tasty.

 

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