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Bridging the Week: November 14 to 18 and November 21, 2016 (Sarao, Coscia and Spoofing; Friends and Family Hiring; Politicians Tell Regulators Put Pens Down) [VIDEO]

Last week, the federal court hearing the Commodity Futures Trading Commission’s enforcement action against alleged Flash Crash spoofer Navinder Sarao accepted his settlement offer proposed two weeks ago, while a three-judge panel of a federal court of appeals appeared to be sympathetic to Michael Coscia when it heard arguments to overturn his November 2015 conviction for spoofing on November 10. Separately, Mary Jo White announced her imminent resignation as SEC Chair while Timothy Massad, CFTC chairman, was urged to put pens down by K. Michael Conaway, Chairman of the US House of Representatives Committee on Agriculture, regarding CFTC consideration of revised position limits rules, Regulation Automated Trading and the cross-border application of its swap dealer registration requirements. As a result, the following matters are covered in this week’s edition of Bridging the Week:

  • Federal District Court Approves Flash Crash Spoofer’s US $38 Million Settlement; Federal Appeals Court Appears Sympathetic to Michael Coscia’s Claim That Spoofing Prohibition Is Too Vague (includes My View);

  • Bank Settles SEC and FRB Charges That It Violated Federal Law by Hiring Relatives and Friends of Asia-Based Government Officials (includes Compliance Weeds);

  • CME Group Adds New Provisions to Wash Trades Guidance Regarding Indirect Transactions and Pre-Open Activity (includes Compliance Weeds);

  • Introducing Broker Resolves ICE Futures U.S. Charges Related to Delayed Block Trade Reporting; Another CME Group Member Settles for Faulty ATS;

  • Broker-Dealer Sanctioned Over $3.3 Million for Not Making Required Regulator Filings With FINRA and Not Producing Documents in Discovery to Arbitration Claimants;

  • Political Update: SEC Chair Announces Imminent Resignation; CFTC Chairman Urged to Put Pens Down on Three Controversial New Initiatives;

  • CFTC Reminds Market Participants of New Form 40 and 71 Requirements (includes Compliance Weeds); and more.

Federal District Court Approves Flash Crash Spoofer’s US $38 Million Settlement; Federal Appeals Court Appears Sympathetic to Michael Coscia’s Claim That Spoofing Prohibition Is Too Vague

The US federal court handling the civil case brought by the Commodity Futures Trading Commission against Navinder Sarao for alleged spoofing activity accepted the settlement agreement jointly submitted by the CFTC and Mr. Sarao two weeks ago. Under the terms of this agreement, Mr. Sarao will pay a fine of over US $25.74 million, disgorge profits of over US $12.87 million and be permanently barred from trading on CFTC-supervised markets, among other sanctions.

The CFTC filed its complaint against Mr. Sarao in April 2015, charging him and his trading company, Nav Sarao Futures Limited PLC, with engaging in spoofing and layering activity involving E-mini S&P futures contracts traded on the Chicago Mercantile Exchange from April 2010 through April 2015 that netted him profits in excess of US $40 million. Mr. Sarao was specifically accused of having engaged in illicit trading that contributed to the May 6, 2010, “Flash Crash.” (The “Flash Crash” refers to events on May 6, when major US-equities indices in the futures and securities markets suddenly declined 5-6 percent in the afternoon in a few minutes before recovering within a similarly short time period.)

Two weeks ago, Mr. Sarao also pleaded guilty to criminal charges brought by the Department of Justice related to the same essential conduct; he awaits sentencing in connection with this matter.

Separately, three judges of the US Court of Appeals for the Seventh Circuit heard oral arguments on November 10 related to Michael Coscia’s efforts to set aside his November 2015 criminal conviction on six counts of commodities fraud and six counts of spoofing in connection with his trading activities on CME Group exchanges and ICE Futures Europe from August through October 2011. During his presentation, Mr. Coscia’s counsel principally argued that the provision of law prohibiting spoofing under which Mr. Coscia was prosecuted had not given him adequate notice of what trading activity was precisely prohibited. This was because the relevant provision of law did not define spoofing and, prior to the time of Mr. Coscia’s alleged wrong conduct, the CFTC provided no guidance regarding what constituted prohibited spoofing.

The relevant provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act under which Mr. Coscia was prosecuted first became effective in July 2011, one month prior to the initiation of his alleged wrongful conduct. (Click here to access the relevant anti-spoofing provision, Commodity Exchange Act Sec. 4c(a)(5)(C), 7 US Code Sec. 6c(a)(5)(C).)

The judges hearing the case asked counsel for both Mr. Coscia and the United States to distinguish differences between contingent orders and orders that constituted spoofing, and to opine whether spoofing solely represented an evolution of market practices to address high-speed algorithmic trading. The judges appeared sympathetic to the fact that Mr. Coscia’s conviction was the first prosecution under the new Dodd-Frank provision outlawing spoofing. (Click here for background on Coscia’s sentencing and criminal conviction.)

My View: As I have written before, the anti-spoofing provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act that prohibits trading activity that “is, is of the character of, or is commonly known to the trade as, ‘spoofing’ (bidding or offering with the intent to cancel the bid or offer before execution)” is badly drafted because it uses a term that is assumed to be commonly understood and is followed by a parenthetical that is too broad in scope. 

It may seem clear to many what is prohibited by this provision, but by its broad sweep, the provision technically makes illegal relatively ordinary trading conduct that no one – not even the Commodity Futures Trading Commission or any exchange – would likely consider nefarious.

For example, when a trader places a stop-loss order, he or she does not intend for the order to be executed, because presumably that would mean the market is trending in a direction opposite his or her view or expectation. However, he or she would accept an execution if the conditions of the stop-loss order was realized. The CFTC, in its May 28, 2013 Antidisruptive Practices Authority guidance (click here to access) seems to acknowledge this dichotomy. According to the CFTC, “a spoofing violation will not occur when the person’s intent when cancelling a bid or offer before execution was to cancel such bid or offer as part of a legitimate, good-faith attempt to consummate a trade. Thus the Commission interprets the statute to mean that a legitimate, good-faith cancellation or modification of orders (e.g., partially filled orders or properly placed stop-loss orders) would not violate [the spoofing prohibition].”

CME Group, in its interpretation of its rule related to market disruption, goes even further by suggesting there is a difference between intent and hope when placing an order. According to CME, “[m]arket participants may enter stop orders as a means of minimizing potential losses with the hope that the order will not be triggered. However, it must be the intent of the market participant that the order will be executed if the specified condition is met.” (Click here to access CME Group Advisory, RA-1516-5.)

Potentially, every individual that a regulator might seek to prosecute for spoofing will likely hope that some orders might not be executed, but is likely okay for the orders to be executed if they are — i.e., if the specified market conditions are met!

Moreover, in its Advisory, CME Group also provides a number of other examples where the intent of a trader is not necessarily to have all his or her orders executed at the time of order placement, but the consequence is not deemed impermissible spoofing — e.g., placing a quantity larger than a market participant expects to trade in electronic markets subject to a pro rata matching algorithm and placing orders at various price levels throughout an order book solely to gain queue position, and subsequently cancelling those orders as markets change.

Unfortunately, the statute prohibiting spoofing simply has it wrong. There is nothing automatically problematic about all spoofing as now defined under applicable law. Deception, to some extent, is part of smart trading. No trader knowingly reveals all his or her strategy or intent as part of an order placement. Using iceberg orders to disguise order volume is expressly legitimate, for example. As CME Group wrote in a comment letter to the CFTC about what should be deemed illegal spoofing, it is not the intent to cancel orders before execution that is necessarily problematic, it’s “the intent to enter non bona fide orders for the purpose of misleading market participants and exploiting that deception for the spoofing entity’s benefit” (emphasis added; click here to access CME letter to CFTC dated January 3, 2011).

The appellate judges hearing the Coscia appeal spent of lot of time listening to arguments regarding the distinction between hope and intent, the nature of algorithmic trading and how conduct characterized as spoofing might fit into modern markets. Until the spoofing prohibition is clarified to reflect what truly is problematic, it will embrace both legitimate and illegitimate activity, potentially scare away bona fide trading and have a deleterious impact on market liquidity, and inadvertently cause some market participants to run afoul of the law for ordinary order placement activity.

No matter what the outcome of Mr. Coscia’s appeal, the law’s prohibition against spoofing should be amended to not capture commonly accepted legitimate trading activity and to more carefully capture solely what is wrongful conduct.

Briefly:

  • Bank Settles SEC and FRB Charges That It Violated Federal Law by Hiring Relatives and Friends of Asia-Based Government Officials: JPMorgan Chase agreed to settle civil charges brought by the Securities and Exchange Commission and the Board of Governors of the Federal Reserve System that, between 2006 and 2013, it provided jobs and internships to relatives and friends of Asia-based government officials, including China government officials, to retain or obtain investment banking business. The SEC said this conduct violated a federal law known as the Foreign Corrupt Practices Act. (Generally, the FCPA prohibits the payment or offer of payment of anything of value to a foreign official to influence any act or decision of such person in his or her official capacity or to secure any other improper advantage to obtain or retain business. Click here to access the FCPA.) According, to the SEC, during this time, JPMorgan Securities (Asia Pacific) Limited, an affiliate, established and maintained a referral hiring program, informally referenced at the firm as the “Sons & Daughters Program.” Within this program, said the SEC, JPMorgan APAC processed the referral of relatives and friends of senior executives of clients and prospective clients, and senior government officials, including senior officers at many state-owned enterprises in China. Candidates in this program were not subject to JPMorgan’s ordinary rigorous competitive vetting process, but an alternative noncompetitive hiring scheme. This was despite the firm having a toughly worded anticorruption policy that prohibited the hiring of individuals to win business. To resolve these charges, JPMorgan agreed to pay more than US $130 million in disgorgement to the SEC and US $61.9 million as a fine to the Federal Reserve. In a related matter, JPMorgan APAC agreed to pay a penalty of US $72 million to the US Department of Justice and to enter into a non-prosecution agreement in connection the same essential activity. The SEC noted that it did not impose a fine on JPMorgan because of JPMorgan APAC’s agreement to pay a fine to the DOJ. JPMorgan also agreed to various reporting obligations to the SEC and Fed regarding its progress in implementing enhanced compliance procedures to comply with US law regarding hiring practices.

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, in A Resource Guide to the U.S. Foreign Corrupt Practices Act, a very helpful guide to the FCPA (click here to access), DOJ and SEC staff note 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 to all US “domestic concerns” (e.g., all US citizens, nationals, residents and incorporated entities); issuers: and their officers, directors, employees, agents; and shareholders; and certain foreign nationals or entities too while acting in the US.

  • CME Group Adds New Provisions to Wash Trades Guidance Regarding Indirect Transactions and Pre-Open Activity: CME Group proposed to amend its market guidance related to wash trades to make clear that its self-match prevention functionality does not prevent self matches on the opening of a market where the orders were entered in to the pre-open state on Globex. In its proposed revised guidance, CME Group also made clear that it would consider it a violation of its prohibition against wash trading for a person to enter orders during a pre-open state that it knew or should have known would match. An example of such orders would be a buy order placed above the price of a resting sell order, or a sell order placed below the price of a resting buy order. In addition, CME Group noted that indirect wash trades as well as direct wash trades are not permitted. CME posited, as an example, that a prohibited indirect wash trade would include a situation where three traders signed up for an incentive or rebate program and, with or without prearrangement, executed a series of transactions in close time proximity, buying and selling similar quantities against each other, and at the conclusion of trading the traders had no change in position. “Transactions executed for the purpose of increasing volume, while knowing or having reason to know the transactions would not be exposed to price competition or the positions exposed to market risk, are considered [impermissible] wash trades,” wrote the CME Group. Absent CFTC objection, CME Group’s proposed revised guidance, in the form of a market regulation advisory notice, will be effective December 1.

Compliance Weeds: A wash trade is a type of fictitious trade where a transaction or series of transactions give the appearance of bona fide purchases or sales, but in fact are entered into without the intent to take a bona fide market position or to expose the transactions to market risk or price competition. Specifically, CME Group prohibits as wash trades three types of conduct:

  1. placing or accepting buy and sell orders in the same product and expiration month, or for a put or call option, in the same strike price, where the person placing or accepting the orders “knows or reasonably should know that the purpose of the orders is to avoid taking a bona fide market position exposed to market risk”;

  2. entering buy and sell orders for different accounts with common beneficial ownership “with the intent to negate market risk or price competition”; or

  3. knowingly executing or accommodating the execution of either of the types of orders in 1 or 2, above. (Click here to access CME Group Rule 534.)

(Keep in mind that the Commodity Exchange Act Sec. 4c(a)(2), 7 U.S. Code Sec. 6c(a)(2)(A)(i) also prohibits transactions that are, are of the character of, or commonly known to the trade as a “wash sale”; click here to access. Other exchanges also have equivalent prohibitions. Click here, e.g., for Wash Sales FAQ of ICE Futures U.S.) According to the CME, a wash trade requires a “wash result,” meaning the purchase and sale of the same instrument at the same price or a similar price for accounts with the same beneficial ownership or for accounts with common beneficial ownership. There is no de minimis for common ownership. In addition, parties’ intent to achieve a wash result may be inferred from evidence of (a) prearrangement or (b) that the orders were structured, entered or executed in a manner that the party(ies) knew or reasonably should have known would produce a wash result. The following would not be considered wash sales:

  1. buy and sell orders for accounts with common beneficial ownership that are independently initiated for legitimate and separate business purposes by independent decision makers that coincidentally cross; or

  2. orders generated by algorithms operated and controlled by different trading groups that unintentionally and coincidentally cross,

provided there is no prearrangement and neither party had knowledge of the other’s order or had intent to cross. However, such trades will be subject to heightened scrutiny. Again, a person who executes or accommodates transactions (as well as initiates) that they know or reasonably should know will end in a wash result, will violate the CME Group’s prohibition against wash trades.

  • Introducing Broker Resolves ICE Futures U.S. Charges Related to Delayed Block Trade Reporting; Another CME Group Member Settles for Faulty ATS: Atlas Commodities, LLC, a Commodity Futures Trading Commission-registered introducing broker, agreed to pay a fine of US $65,000 to resolve a disciplinary action brought by ICE Futures U.S. that it failed to properly handled block trades for its customers. According to IFUS, Atlas may have on unspecified “multiple occasions” misreported to it the correct execution time of block trades; reported such trades beyond the 15-minute required reporting period; and failed to have adequate procedures to ensure correct trade details were reported to it. IFUS said that Atlas also might not have recorded and maintained oral records related to the execution of a consummated block trade, as required for non-member IBs. Separately, a member firm resolved a disciplinary action with the Chicago Mercantile Exchange by agreeing to pay a fine of US $42,500. CME had alleged that, between December 2014 and January 2015 and again in April 2015, the firm, using an algorithmic trading program, entered incrementally widening spreads between the bid and offer prices in CME’s equity options markets, “causing aberrant bid and offer prices.” CME acknowledged that the member firm fixed this problem in January 2015, but alleged it failed to include this fix in a subsequent update of its ATS; this caused the problem to reoccur in April.

  • Broker-Dealer Sanctioned Over $3.3 Million for Not Making Required Regulator Filings With FINRA and Not Producing Documents in Discovery to Arbitration Claimants: Oppenheimer & Co, Inc. agreed to pay a fine of US $1.575 million and remediation payments to customers of US $1.846 million to resolve a disciplinary action against it brought by the Financial Industry Regulatory Authority that it failed to report certain required information to FINRA; failed to apply applicable sales charge waivers to its customers; and did not produce relevant documents to customers who had filed arbitrations against it, as required. Among other specific allegations, FINRA claimed that from October 20, 2008, through February 18, 2016, the firm failed to make 365 required reports to it, including reports of disciplinary actions; between January 2009 and August 2016, sold to certain retirement plan and charitable organization customers that were eligible to purchase certain mutual funds without front-end sales charges, shares that had such charges, or with backend sales charges with higher ongoing fees and expenses; and between 2010 and 2013, failed to provide seven arbitration claimants certain responsive documents they requested. Oppenheimer and Co. entered into the settlement with FINRA without admitting or denying any of FINRA’s findings.

And more briefly:

  • SEC Approves Consolidated Audit Trail and Three-Year Phase-In: The Securities and Exchange Commission approved creation of a single comprehensive database to track all trading activity in US national market system equities and options in order to assist its and self-regulatory organizations’ surveillance of US market activity. Among data to be reported to and captured by the CAT will be the identity of the customer and lifecycle events related to each trade. Within two months, SROs are required to select a plan processor to build and operate the CAT. Within one year, SROs will be required to report all required information to the CAT while large broker-dealers will have this obligation beginning in two years and all remaining broker-dealers in three years.

  • Five Regulated Clearinghouses Pass CFTC-Administered Stress Tests: Five principal Commodity Futures Trading Commission-registered clearinghouses demonstrated they had the financial resources to withstand a variety of extreme market price changes across a wide range of products and instruments during its first supervisory stress test of clearinghouses. The five clearinghouses were CME Clearing, ICE Clear Credit, ICE Clear Europe, ICE Clear U.S. and LCH Clearnet Ltd. The exercise covered the 15 largest clearing members at each clearinghouse and encompassed 11 different stress scenarios. According to the CFTC, its stress tests showed that all the clearinghouses had sufficient financial resources to cover a default by at least the two clearing members with the largest margin shortfalls – the base standard under US and international requirements for systemically important clearinghouses.

  • CME Group Amends Block Trade Guidance to Conform With ICE Futures U.S. Guidance; FIA Hosts Exchange Webinar on New Guidances Today: CME Group amended its block trade market regulation advisory notice to conform with recent language adopted by ICE Futures U.S. related to permissible pre-hedging by principals to the transactions. Under the revised CME Guidance, it would be a violation of the CME Group rule dealing with block trades for a person to front run a block trade when acting on material nonpublic information obtained through a “confidential employer/employee relationship, broker/customer relationship or in breach of a pre-existing duty.” Currently, the term “fiduciary duty” is written in the CME guidance instead of the term “pre-existing duty.” FIA will be hosting a webinar this afternoon at 1 pm ET by CME Group, IFUS and NASDAQ Futures to discuss their block trade guidances (click here to register).

  • UK FCA Raises Concerns Regarding Weak Price Competition in the Asset Management Sector: In connection with a market study launched in November 2015 to determine whether competition is working effectively, the UK Financial Conduct Authority concluded that there is limited price competition for actively managed funds. As a result, noted FCA investors often pay high charges that are not justified by higher returns. There is stronger competition for passively managed funds, observed FCA. Additionally, said FCA, fund objectives are not always clear or reported against an appropriate benchmark. In response, FCA proposed a number of remedies including an enhanced duty of asset managers to act in the best interests of investors including requiring assets managers to explain how they deliver value for money. FCA will accept comments on its interim findings and proposals through February 20, 2017.

  • Federal Reserve Imposes Greater Post-Employment Restrictions for Senior Examiners: The Board of Governors of the Federal Reserve System enacted more severe restrictions on potential compensation that may be accepted by senior examiners after ceasing employment and expanding the definition of senior examiner. For example, under its new rules, any senior examiner may not accept any compensation for one year from a bank holding company or any depository institution controlled by the BHC for one year after leaving the Fed if during two or more months in the last 12 months at the Fed he/she was a senior examiner of the BHC. In addition, current Fed employees are barred for one year from discussing official business with former Fed officers. In November 2015, Rohit Bansal, a former employee of Goldman, Sachs & Co and the New York Federal Reserve Bank, and Jason Gross, a former employee of the New York Fed only, pleaded guilty to charges related to the unauthorized use of nonpublic confidential information by Mr. Bansal while employed by Goldman which he obtained from Mr. Gross. (Click here for details.)

  • FINRA Rule Proposal Requiring Enhanced Disclosure to Retain Clients Regarding Corporate and Agency Fixed Income Securities Approved by SEC: The Financial Industry Regulatory Authority received approval from the Securities and Exchange Commission to implement a proposed rule requiring members to disclose on retail customer confirmations the mark-up or mark-down for most corporate and agency debt securities transactions. The confirmation will also have to include the execution time and a hyperlink (if the confirmation is electronic) to trade price data in the security from FINRA’s Trade Reporting and Compliance Engine, commonly known as "TRACE." No effective date was announced.

Follow-up:

  • Political Update: SEC Chair Announces Imminent Resignation; CFTC Chairman Urged to Put Pens Down on Three Controversial New Initiatives: As anticipated, Mary Jo White announced she will resign as Chair of the Securities and Exchange Commission prior to January 20, 2017. In addition, House of Representatives Majority Leader Kevin McCarthy issued a letter to all agency commissioners cautioning them against finalizing any pending rules or regulations in the Obama administration’s last days. Mr. McCarthy threatened that, if his request was not followed, Congress might overturn any relevant regulation pursuant to the Congressional Review Act. (The CRA permits Congress to review new federal regulations through an expedited process and overturn a regulation by a joint resolution. Click here to access the CRA). Separately, K. Michael Conaway, Chairman of the US House of Representatives Committee on Agriculture, wrote to Timothy Massad, Chairman of the Commodity Futures Trading Commission, specifically requesting deferral of consideration of new position limits rules, Regulation Automated Trading and the cross-border application of its swap dealer registration requirements. There has been no formal public response by Mr. Massad to Mr. Conaway's exhortation.

  • CFTC Reminds Market Participants of New Form 40 and 71 Requirements: The Commodity Futures Trading Commission’s Division of Market Oversight issued a press release formally reminding market participants of new reporting obligations for Forms 40/40S and Form 71 as of last Friday (Form 40s/40Ss are requested by special call by the CFTC to reporting traders while Form 71s are also requested by special call by the CFTC to all so-called omnibus volume threshold accounts.)

Compliance Weeds: While end users’ attention is rightfully fixated on the new electronic Form 40 and 40S and their new questions, agricultural merchants and hedgers should not forget their obligations to file CFTC Form 204s and 304s as necessary. CFTC Form 204 (Statement of Cash Positions in Grains, Soybeans, Soybean Oil and Soybean Meal) and Parts I and II of Form 304 (Statement of Cash Position in Cotton – Fixed Price Cash Positions) must be filed by any person that holds or controls a position in excess of relevant federal speculative position limits that constitutes a bona fide hedging position under CFTC rules. These documents must be made as of the close of business on the last Friday of the relevant month. Form 204 must be received by the CFTC in Chicago by no later than the third business day following the date of the report, while Form 304 must be received by the Commission in New York by no later than the second business day following the date of the report. Part III of Form 304 (Unfixed Price Cotton “On-Call”) must be filed by any cotton merchant or dealer that holds a so-called reportable position in cotton (i.e., pursuant to large trader reportable levels; click here access CFTC Rule 15.03) regardless of whether or not it constitutes a bona fide hedge. Form 304 (Part III) must be made as of the close of business on Friday every week, and received by the CFTC in New York by no later than the second business day following the date of the report. Form 204s and 304s remain paper forms!

And finally:

  • Tom Sexton Named President and CEO Effective March 1, 2017: The National Futures Association announced that Thomas Sexton would become President and CEO as of March 1, 2017, replacing retiring President and CEO, Daniel Roth. Congratulations, Tom!

©2019 Katten Muchin Rosenman LLP

TRENDING LEGAL ANALYSIS


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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