Bridging the Week by Gary DeWaal: January 14 – 18 and January 22, 2019 (Hacking at the SEC; Digital Assets; Spoofing) [Video]
Last week the Securities and Exchange Commission filed an enforcement action against nine defendants related to its 2017 discovery that its Electronic Data Gathering, Analysis, and Retrieval (EDGAR) system used for receiving and retaining various corporate filings had been hacked and that persons likely had traded on material nonpublic information obtained through the cyber intrusion. A related criminal indictment organized by the Department of Justice was also filed. Separately, during the prior week, the first person convicted and sentenced to serve time in prison for spoofing under the Dodd-Frank Wall Street Reform and Consumer Protection Act requested a new trial based on data he claimed was not made available for use by relevant exchanges during his initial trial. As a result, the following matters are covered in this week’s edition of Bridging the Week:
Nine Persons Charged by SEC in EDGAR Hacking and Illicit Trading Scheme; Two Persons Additionally Named in Criminal Indictment (includes Compliance Weeds);
Follow-up: First Person Convicted and Sentenced Under Dodd-Frank Anti-Spoofing Law Seeks New Trial (includes My View); and more.
Nine Persons Charged by SEC in EDGAR Hacking and Illicit Trading Scheme; Two Persons Additionally Named in Criminal Indictment: The Securities and Exchange Commission filed a civil lawsuit against Oleksandr Ieremenko and eight other persons for allegedly conducting an illegal trading scheme that relied on material nonpublic information illicitly obtained through cyber attacks on the SEC’s online Electronic Data Gathering, Analysis, and Retrieval system used by the SEC for receiving and retaining various corporate filings. The SEC charged that the alleged illicit conduct occurred from May through at least October 2016.
In its complaint, filed in a federal court in New Jersey, the SEC alleged that Mr. Ieremenko was the architect of the fraudulent scheme. According to the SEC, he initiated his purportedly nefarious activity in spring 2016 by first sending emails containing malware to sec.gov addresses that appeared to originate with SEC security personnel. Through this phishing attack, Mr. Ieremenko was able to (1) infect several SEC workstations when some SEC computer users opened emails with the malware; (2) illicitly penetrate the EDGAR system; and ultimately (3) gain access to test filings made by reporting entities on EDGAR, some of which contained nonpublic earnings information that would be publicized by the filing companies in the near future. Mr. Ieremenko then sold some of the earnings information to the other defendants, who bought and sold securities of the filing companies in advance of the public announcements of such information, hoping to benefit from their early knowledge. Ultimately, charged the SEC, this generated at least US $4.1 million in gross illicit gains.
The eight persons named in the SEC’s enforcement action in addition to Mr. Ieremenko were: Capyield Systems, Ltd.; Sungjin Cho, David Kwon, Ivan Olefir, Igor Sabodakha, Andrey Sarafanov, Spirit Trade, Ltd., and Victoria Vorochek. All the defendants were alleged to have ties with either Russia or Ukraine, except for Mr. Cho and Mr. Kwon whose last known addresses were in California.
All the defendants, except for Spirit Trade and Mr. Kwon, were charged by the SEC in 2015 in connection with a similar cyber intrusion and trading program involving material nonpublic information illegally obtained from newswire services. (Click here for further details in the article “Hackers and Traders Charged by SEC and Department of Justice in International Securities Fraud Scheme” in the August 16, 2015 edition of Bridging the Week.)
In a parallel action, Mr. Ieremenko and Artem Radchenko – who allegedly recruited the parties that traded on the hacked information – were indicted in a criminal action initiated by the Department of Justice. The criminal action covers the defendants’ activities from February 2016 to March 2017.
Among other remedies, the SEC seeks disgorgement and penalties against the defendants. The DOJ seeks fines and imprisonment among other sanctions.
Compliance Weeds: In September 2017, in an innocuous press release entitled “SEC Chairman Clayton Issues Statement on Cybersecurity” the SEC first announced that it had discovered that its EDGAR system was hacked during 2016 and that persons may have profited from trading on unauthorized information obtained through such intrusion. (Click here for details in the article “SEC Discloses Trading May Have Occurred Based on Confidential Information Illicitly Obtained From Hack of EDGAR System in 2016” in the September 24, 2017 edition of Bridging the Week.) At the time, the SEC said that it did not believe that the hacking resulted in the compromise of personally identifiable information. Additionally, the SEC said that the hacking occurred through the test-filing component of the EDGAR system and that the vulnerability that allowed the hacking was patched “promptly after discovery.”
Just a short time later, the SEC acknowledged that, despite its prior understanding, the hack of the EDGAR system compromised two individuals’ personal information. (Click here for more information in the article “SEC Chairman Discloses Personal Information Also Compromised in EDGAR Hack” in the October 8, 2017 edition of Bridging the Week.) Moreover, in its complaint against defendants, it appears that the vulnerability in the EDGAR system that Mr. Ieremenko exploited was not shut down because of a detection of his illicit activity, but because of an unrelated incident. According to the SEC, “In October 2016, SEC IT personnel patched EDGAR software in response to a detected attack on the system, which also had the effect of preventing Ieremenko from accessing test filings” (emphasis added).
As this embarrassing episode at the SEC confirms, it’s not if a cyber attack may occur, it’s when it will occur. Unfortunately, the bad folks are too creative and always seem to be one step ahead of the rest of us. As SEC Chairman Jay Clayton said in announcing the SEC enforcement action against the nine defendants, "[n]o system can be entirely safe from a cyber intrusion." (Click here to access Mr. Clayton's full statement on the SEC's enforcement action.)
There are numerous well-publicized measures a financial services firm should take to help reduce the likelihood of a cyber attack, including training (which should include mock phishing exercises). Equally important are the measures a firm should take to respond to a cyber attack, including taking all reasonable measures to understand the nature and scope of an attack and securing systems and data as soon as possible. Key is to have developed in advance a well thought through formal attack response plan and follow it when an attack occurs. Recent publications by the Financial Industry Regulatory Authority and amendments to National Futures Association’s guidance related to Information Systems Security Programs are good starting documents to review to gain better insight into effective cybersecurity measures. (Click here for information regarding the FINRA publication in the article “FINRA Publicizes Effective Practices at Members to Mitigate Cybersecurity Risks” in the January 6, 2019 edition of Bridging the Week, and here regarding NFA’s revised NFA guidance in the article “NFA Proposes Guidance Amendments to Enhance Cybersecurity” in the December 9, 2018 edition of Bridging the Week.)
Canadian Regulatory Organization Also Emphasizes Digital Assets and Cybersecurity in Latest Priorities Report: The Investment Industry Regulatory Organization of Canada previewed areas of likely regulatory attention in 2019 based on issues identified throughout its 2018 compliance and registration activities. Among the areas of focus are cybersecurity, electronic trading controls, best execution, wash trading, compensation-related conflicts of interest, and issues around automated/online advice services. IIROC also noted that, in conjunction with the Canadian Securities Administrators, it is working to develop “an appropriate regulatory framework” for digital assets that will address both market integrity and investor protection. No details were provided. However, last year CSA issued guidance regarding when digital tokens are subject to securities laws and not utility tokens. (Click here for background in the article “Anything but Sleep Inducing: SEC Corporate Finance Director Says Ether Not a Security and Canada Issues Guidance on Utility Tokens” in the June 17, 2018 edition of Bridging the Week.)
Earlier this year, the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations said that digital assets, cybersecurity, and anti-money laundering programs would be among its top priorities during its 2019 reviews of registrants. (Click here for details in the article “Offer and Sale of Digital Assets and Cybersecurity Among the Focus of SEC OCIE 2019 Examination Priorities” in the January 6, 2019 edition of Bridging the Week.)
IIROC is the self-regulatory organization which oversees all investment dealers and trading activity on debt and equity marketplaces in Canada.
In additional legal developments regarding crypto assets:
Wyoming Proposes Laws to Permit Companies to Issue Digital Tokens in Lieu of Stock Certificates and for Banks to Provide Custodial Services for Digital Assets: Representatives in Wyoming’s House of Representatives introduced a proposed law that would authorize corporations to issue all or a portion of their shares in the form of certificate digital tokens instead of stock certificates. As proposed, a certificate token would be a representation of shares containing certain required information where the information is entered on a blockchain or other secure and auditable database; is linked to the certificate token; and is able to be transmitted to the issuing corporation, the person to whom the certificate token was issued and any transferee. Separately, Wyoming legislators introduced another bill that would classify digital assets within existing Wyoming laws; specify that digital assets are "property" for purposes of commercial law; and provide a framework for banks to provide custodial services for digital assets. As proposed, digital assets would be digital consumer assets (i.e., digital assets that are used or bought principally for consumptive, personal or household purposes), digital securities and virtual currencies.
Congressman Reintroduces Bill to Exempt Certain Crypto Companies from State Money Transmitter Statutes: Congressmen Tom Emmer and Darren Soto reintroduced a bill in the new Congress that would exempt from registration as a money transmitter in any state or as a money service business with the Financial Crimes Enforcement Network of the US Department of Treasury any blockchain developer or provider of blockchain services that does not accept funds from consumers. This bill had previously been introduced during the last term of Congress.
NFA to Members: Be Careful Dealing With Exempt CTAs and CPOs During First Quarter 2019: The National Futures Association issued its annual reminder that members dealing with lawfully exempt-from-registration commodity trading advisors and commodity pool operators should take “reasonable steps” through the first quarter of 2019 to ensure such persons are lawfully exempt. This is because lawfully exempt CTAs and CPOs have until March 1 to file with NFA an annual affirmation regarding their exemption and, if they do not, may be required to be registered. Reasonable steps, said NFA, include reviewing certain information regarding such CPOs and CTAs it provides online. NFA members are not permitted to conduct a customer business with persons required to be registered with the Commodity Futures Trading Commission and members of NFA who are not.
SEC Study of Corporate Trading Plans to Avoid Insider Trading Abuses Required by House Committee Members in Proposed Law: Two members of the House Committee on Financial Services – Chair Maxine Waters and Ranking Member Patrick McHenry – proposed bipartisan legislation that would require the Securities and Exchange Commission to study and report back to the Committee within one year whether amendments to a current SEC rule authorizing corporate insiders to effectuate trades pursuant to pre-established trading plans should be amended to enhance prohibitions against insider trading (click here to access the relevant existing SEC Rule 10b5-1). Under the proposed law, the SEC would also be required to evaluate whether any amendments to its trading plan rule might inhibit the ability of corporations to hire prospective employees that would become insiders and the general impact on capital formation.
First Person Convicted and Sentenced Under Dodd-Frank Anti-Spoofing Law Seeks New Trial: On January 10, Michael Coscia – the first person convicted and sentenced to a prison term under the prohibition against spoofing enacted under the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act – requested a federal court in Chicago to grant him a new trial. Mr. Coscia claimed that a retrial was warranted because, in his initial hearing, the government had claimed that his pattern of trading was “unique and extraordinary.” However, claimed Mr. Coscia, the trading data utilized during the trial was for a “narrow, incomplete set of dates, futures and traders.” Only after his trial, alleged Mr. Coscia, did CME Group and the Intercontinental Exchange produce broader sets of data that showed that the ratio of his canceled orders to executions was not unusual and that his “trading activity was the same as hundreds of other traders.”
Mr. Coscia was sentenced to three years’ imprisonment for spoofing and commodity fraud following a criminal trial in 2015 for three months of trading activity in 2011; he previously settled civil charges related to the same matter with the Commodity Futures Trading Commission, the Financial Conduct Authority, and certain CME Group exchanges. (Click here for background in the article “Michael Coscia Sentenced to Three Years’ Imprisonment for Spoofing and Commodity Fraud” in the July 17, 2016 edition of Bridging the Week.)
The US Supreme Court declined to hear a proposed appeal of Mr. Coscia’s conviction during May 2018. (Click here for details in the article “Supreme Court Declines to Hear Appeal by the First Person Convicted Under New Anti-Spoofing Law” in the May 20, 2018 edition of Bridging the Week.)
My View: As I wrote at the time of Mr. Coscia’s sentencing, it was somewhat draconian that Mr. Coscia was sentenced to three years in prison for violating what was at the time a new law for which he already paid substantial civil sanctions; which on its face appeared to prohibit at least some legitimate trading practices; and which, at the time, may not have given him adequate notice of prohibited conduct. When the Financial Industry Regulatory Authority announced its issuance of its first cross-market equities report cards aimed at helping member firms identify potential spoofing and layering activity in 2016, it defined spoofing as “entering orders to entice other participants to join on the same side of the market at a price at which they would not ordinarily trade, and then trading against the other market participants’ orders.” This is a comprehensive practical definition. Contrariwise, the relevant provision under which Mr. Coscia was convicted prohibits “spoofing” but defines it as “bidding or offering with the intent to cancel the bid or offer before execution.” However, many legitimate orders, including stop-loss orders, are placed with the goal or hope not to have the order executed, as that would mean the value of a position is declining. Unfortunately for Mr. Coscia, the judge hearing his case – as well as a US Court of Appeals – did not have a problem with the clarity of the relevant statute and, in any case, believed that Mr. Coscia should have known his specific trading was prohibited. (Click here for background on the FINRA report cards in the article “FINRA Will Grade Members on Culture, Supervision and Liquidity Management; BDs Not Managing Spoofing Likely to Get Bad Scores” in the January 10, 2016 edition of Bridging the Week.)