November 29, 2021

Volume XI, Number 333


Bridging the Week: November 17 to 21 and 24, 2014 [VIDEO]

The adequacy (or inadequacy) of critical technology underlying firms’ operations was the undercurrent of important developments in the worldwide financial services industry last week. Also, another week passed, and yet another commissioner at the Commodity Futures Trading Commission indicated that some amendments might be necessary in connection with the agency’s swap execution trading rules.

As a result, the following matters are covered in this week’s Bridging the Week:

  • Broker-Dealer and Two Senior Officers Fined US $2.5 Million for Market Access Violations;

  • US Senate Subcommittee Calls for CFTC Joint Oversight With SEC Over Commodity ETFs and Other Measures in Response to Inquiry of Banks’ Involvement With Physical Commodities (includes My View);

  • SEC Adopts New Rules to Beef-up Technology Backbone of Securities Markets (includes Compliance Weeds);

  • CME Group Sanctions Member for Not Having Adequate Controls to Prevent Automated Trading System Erroneous Response to Bad Data;

  • UK FCA Sanctions Three Related Banks US $66 Million for Lack of Technology Backbone Resiliency;

  • Court Rejects US Bank’s “Unclean Hands” Argument in CFTC PFG-Related Enforcement Action;

  • NYS Financial Watchdog Imposes an Additional Fine on Bank of Tokyo-Mitsubishi UFJ for Misleading Regulators Regarding Prior Settlement (includes My View);

  • CME Group Fines Trader for Spoofing-Type Offense;

  • Another CFTC Commissioner Recommends Amendments to Swaps Trade Execution Rules (includes My View);

  • Industry Organizations Request Basel Committee Reconsider Proposed Treatment of Segregated Customer Margin;

  • Steak and Potatoes Please —But Hold the Insider Tips; Former Public Company CEO Charged With Passing Material Nonpublic Information to Favorite Restaurant Manager (Hard to Believe); and more.

Video Version:

Article Version:

Broker-Dealer and Two Senior Officers Fined US $2.5 Million for Market Access Violations

Wedbush Securities Inc. and two senior officers resolved an enforcement action previously filed against them during June 2014 by the Securities and Exchange Commission alleging violations of the SEC’s market access rule (Reg MAR). The two officers are Jeffrey Bell, the former executive vice president of Wedbush’s Correspondent Services Division, and Christina Fillhart, a senior vice president in the same division.

Reg MAR, which mostly became effective on July 14, 2011, requires broker-dealers to ensure that all trades that pass through their connections with exchanges and other trading venues be subject to certain risk filters to help avoid manipulative conduct.

As part of their settlements, Wedbush agreed to pay a fine of US $2.44 million, while the two individual officers agreed to pay a combined fine of US $85,000. Wedbush also agreed to retain a consultant to review its compliance with regulatory requirements related to its market access business, among other matters.

In entering into the settlement, Wedbush admitted to a detailed and expansive itinerary of facts that accompanied the Commission order, as well as expressly acknowledged that its conduct “violated the federal securities laws.” Mr. Bell and Ms. Fillhart did not admit or deny any of the Commission’s findings.

Among other matters, the SEC alleged that from July 2011 until at least January 2013, Wedbush “failed to establish, document and maintain a system of risk management controls and supervisory procedures reasonably designed to manage the risks associated with its market access business.”

The SEC had alleged that, during the relevant time, Wedbush allowed anonymous foreign traders to send orders involving “billions of shares every month” directly to trading venues without being subject to the required risk filters. According to the SEC, these problems occurred even after SEC staff advised Mr. Bell and Ms. Fillhart of certain concerns regarding one of Wedbush’s largest sponsored access clients just prior to the effective date of Reg MAR.

The SEC also claimed that Wedbush did not have appropriate written supervisory procedures over its market access business, and violated other rules, including Regulation SHO as well as an obligation to preserve certain communications regarding trading instructions. In addition, Wedbush failed to file suspicious activity reports pursuant to the SEC’s anti-money-laundering requirements, claimed the Commission.

In sanctioning Wedbush, the SEC used against the firm comment letters Wedbush had submitted regarding proposed Reg MAR in 2010, as well as a proposed NASDAQ rule change related to market access in 2009. As evidenced by its comment letter regarding Reg MAR, said the SEC, “Wedbush was well aware of the requirements, objectives and importance” of the rule. In connection with its comment letter on NASDAQ’s proposed rule change, the SEC wrote:

[a]lthough proposing certain changes to the Nasdaq proposed rule, [Mr.] Bell and Wedbush stated in the 2009 comment letter that sponsoring non-broker-dealer customers “requires the highest level of due diligence, oversight and controls. In this case, the sponsoring member is also the broker-dealer of record and would be accountable for all the responsibilities as such.” Despite this acknowledgement, one of Wedbush’s largest sponsored access customers was not a broker-dealer registered in the United States, and Wedbush failed to engage in the “highest level of due diligence, oversight and controls.”

In the facts admitted by Wedbush is a statement that the firm “acted willfully.” However, a footnote endeavors to explain the meaning of the phrase:

[a] willful violation of the securities laws means merely “that the person charged with duty knows what he is doing.” … There is no requirement that the actor “also be aware that he is violating one of the [r]ules or Acts.”

US Senate Subcommittee Calls for CFTC Joint Oversight With SEC Over Commodity ETFs and Other Measures in Response to Inquiry of Banks’ Involvement With Physical Commodities

The US Senate Permanent Subcommittee on Investigations issued a report last week and conducted two days of hearings regarding large banks’ involvement with physical commodities.

In general, the report concluded that bank activities involving physical commodities were risky (exposing the banks to “catastrophic event risks”), unfairly mixed banking and commerce (because banks benefit from lowering borrowing costs), and had undue or potentially undue impact on prices. The report also concluded that through their physical commodity activities banks had access to “commercially valuable, nonpublic information that could have provided advantages in their trading activities.” In oral testimony before the Subcommittee on November 20 to 21, bank officials generally disputed these allegations (click here for a sample of media coverage regarding these hearings).

Among the recommendations by the Subcommittee, however, was one proposal that had nothing to do with bank involvement per se with physical commodities. This recommendation was for the Commodity Futures Trading Commission and the Securities and Exchange Commission to be given joint oversight of exchange-traded funds backed by physical commodities; currently, only the SEC is responsible for ETFs. Moreover, said the Subcommittee in its report, “[t]he CFTC should apply position limits to ETF organizers and promoters, and consider banning such instruments due to their potential use in commodity market corners and squeezes.”

Other recommendations by the Subcommittee pertained solely to banks. These included that federal banking regulators, mostly the Board of Governors of the Federal Reserve System, should (1) “reaffirm” the separation of banking and commerce related to physical commodity activities; (2) limit a bank’s physical commodity holdings to five percent of its so-called “Tier 1 Capital;” (3) establish minimum capital and insurance requirements to protect against potential losses; and (4) prevent unfair trading.

Separately, the Board of Governors of the Federal Reserve System announced two internal reviews to assess the completeness of their examinations of large banks. The reviews will principally aim to determine whether decision makers at the regulator have “all necessary information to make supervisory assessments and determinations” and whether they are aware of “divergent views among an examination team regarding material issues.” One review will be conducted by the Fed’s Inspector General and the other by the Fed’s Board itself.

My View: I thought trading to mitigate the risk of a physical position was hedging and that hedging was the nucleus of futures markets —not something bad. If there is a market offense, the CFTC and futures exchanges already have an ample arsenal to address any violations.

SEC Adopts New Rules to Beef-up Technology Backbone of Securities Markets

The Securities and Exchange Commission approved new rules—Regulation System Compliance or Reg SCI—aimed at improving the resiliency of the technological backbone of US securities markets and the SEC’s oversight of such infrastructures.

The SEC’s new rules will govern securities (but not securities futures) exchanges and clearing agencies, the Financial Industry Regulatory Authority, the Municipal Securities Rulemaking Board, securities information processors and alternative trading systems (so-called "dark pools"). However, the rules will only capture ATSs meeting certain minimum volume thresholds and exclude ATSs that trade solely municipal or corporate debt securities.

During her opening remarks at the November 19 SEC open meeting to announce Reg SCI, Chair Mary Jo White noted that the new rules require “technology controls” in five key areas. According to Ms. White:

The covered entities must implement policies and procedures to ensure that their market systems have levels of capacity, integrity, resiliency, availability, and security adequate to maintain their operational capability and promote the maintenance of fair and orderly markets. These entities also need to ensure that their policies and procedures are designed to ensure that their systems operate in compliance with the Exchange Act and their own rules. The rules also now specify a series of minimum standards for these compliance policies and procedures—an important enhancement from the [current] voluntary program.

The new rules, said Commissioner Luis Aguilar, will have specific requirements regarding change management and testing:

The final rules now mandate a set of minimum standards that include a requirement to test all SCI systems, and modifications to such systems, before they are implemented. SCI entities must also devise and implement a set of internal controls to govern all changes to SCI systems. These requirements are important because of the experience with market disruptions that resulted from software changes that were not sufficiently tested prior to implementation.

The rules have heightened requirements regarding so-called “critical SCI systems.” These are systems that support securities clearing agencies’ clearance and settlement systems; openings; reopenings and closings on the primary listed market; trading halts; initial public offerings; the dissemination of consolidated market data; or exclusively-listed securities. Critical SCI systems also include those that “[p]rovide functionality to the securities markets for which the availability of alternatives is significantly limited or nonexistent and without which there would be a material impact on fair and orderly markets.”

At a minimum, policies and procedures regarding SCI systems must address planning estimates for current and future technological requirements; periodic stress tests to assess system performance and accuracy; system development and testing methodology; regular review and testing “to identify vulnerabilities pertaining to internal and external threats, physical hazards and natural or manmade disasters;” business continuity and disaster recovery;  standards to ensure that system design and maintenance accomodates “successful” handling of market data; and monitoring to identify breakdowns,  intrusions  and compliance issues – so-called “SCI Events.”

The rules also establish requirements regarding reporting of SCI Events to the SEC as well as organizations' members and market participants.

Under the new rules, covered market participants must report quarterly to the SEC about their systems changes and conduct an annual review of their compliance with Reg SCI using “objective personnel.” Reports of these annual reviews must be reviewed by certain enumerated senior managers (including, among others, the general counsel and the chief compliance officer) and filed with the SEC. Ultimately, the rule also requires mandatory industry- or sector-wide business continuity and disaster recovery plan testing.

Reg SCI will be effective 60 days after publication in the Federal Register, and covered entities must comply with applicable requirements by nine months afterwards. ATSs will have an additional six months for compliance after they first meet relevant volume thresholds. Entities will have 21 months after the rules’ effective date to comply with industry- or sector-wide testing requirements.

The SEC first issued a proposed version of Reg SCI in March 2013.

(Click here for additional information in the article “SEC Adopts Regulation Systems Compliance and Integrity Rules” in the November 21, 2014 edition of Corporate & Financial Weekly Digest.)

Compliance Weeds: Reg SCI may not be applicable to broker-dealers at this time, let alone many other participants in the financial services industry, but strong controls around technology and software are critical for all financial service participants. Not only is this mandatory as a matter of good business, but despite the lack of proscriptive regulations addressing requirements related to technology infrastructures, regulators are not timid to seek redress against market participants for breakdowns relying on other regulations in their arsenal. In just this edition of Bridging the Week, there are reports of Credit Suisse Securities in the United States and RBS Group companies in the United Kingdom being fined by regulators because of breakdowns related to their handling of proprietary software. Other prior editions have more examples of enforcement consequences for technology infrastructure breakdowns. It is critical that firms review their technology-related policies and procedures, particularly around system capacity and robustness; software development and amendment, and business continuity and disaster recovery, all along the general principles of Reg SCI. Procedures also need to exist outlining what to do when things go wrong (including notifications) particularly setting forth strict time frames by when firms will switch to disaster recovery mode. Compliance with these procedures should be formally reviewed on a regular basis.

And briefly:

  • CME Group Sanctions Member for Not Having Adequate Controls to Prevent Automated Trading System Erroneous Response to Bad Data: Credit Suisse Securities (USA) LLC settled a disciplinary action brought by the CME Group for a January 30, 2012 incident where the firm’s automated trading system entered and executed an excessive quantity of futures transactions causing a “higher than usual volume in those contracts.” Prior to this incident, a third-party vendor had apparently included an incorrect stock price in an index. Credit Suisse’s automated trading system relied on this errant index to incorrectly calculate the number of futures contracts to be traded—thus prompting the extraordinary order generation. According to the CME Group, “Credit Suisse failed to have sufficient or adequate controls in place to prevent erroneous or incorrect third-party data from impacting the operation of its ATS.” CME Group charged Credit Suisse with violating its prohibition against committing “an act which is detrimental to the interest or welfare of the Exchange.” Credit Suisse agreed to pay a fine of US $150,000 to resolve this matter. Credit Suisse Securities previously paid a fine of US $25,000 to ICE Futures U.S. for ATS breakdowns on April 8, 2011, and January 31, 2012.

  • UK FCA Sanctions Three Related Banks US $66 Million for Lack of Technology Backbone Resiliency: The UK Financial Conduct Authority sanctioned three related banks for IT failures during June 2012 that precluded customers from accessing their accounts and engaging in banking activities. The three banks—all part of the RBS Group—are Royal Bank of Scotland Plc, National Westminster Bank Plc and Ulster Bank Ltd. The malady impacted 6.5 million customers in the United Kingdom and some outside of it too. According to the FCA, the problem arose because of incompatibility between an old version and an upgraded version of relevant software. When installation of the new software failed after it was installed on June 17, 2012, the banks endeavored to revert to the old version on June 19, but this caused a system breakdown. FCA claimed that “[t]he underlying cause of the IT incident was the failure of the [b]anks to meet their obligations to have adequate systems and controls to identify and manage their exposure to IT operational risk.” Specifically, FCA faulted the banks for not taking “reasonable steps” to manage a change to their IT systems, including not having adequate processes to handle IT incidents and to test software. To resolve this matter, the banks agreed to pay a financial penalty of GBP 42 million (approximately US $66 million). The banks had previously paid almost GBP 71 million (approximately US $111 million) to customers and non-customers related to this incident.

  • Court Rejects US Bank’s “Unclean Hands” Argument in CFTC PFG-Related Enforcement Action: The US federal court in Iowa, hearing the enforcement action against US Bank, N.A. by the Commodity Futures Trading Commission related to the bank’s handling of customer funds for Peregrine Financial Group, denied most motions for summary judgment by both parties holding that there are sufficient disputed facts. However, the court expressly rejected US Bank’s argument that the CFTC should not be permitted to proceed with its lawsuit because the bank was prejudiced by the CFTC’s failure to follow through on its staff’s recommendations following a 1999 audit of PFG. In connection with that audit, CFTC staff identified a number of “material violations,” including an “inaccurate segregation record.” Staff also received oral responses that “appeared to be provided as an attempt to mislead the audit process.” As a result, CFTC staff recommended that a warning letter be issued and that the audit be referred to the agency’s Division of Enforcement. Neither was done apparently. However, said the court, “an affirmative defense of unclean hands is unavailable against the government in an enforcement action in the public interest.” The CFTC brought an enforcement action against US Bank in June 2013 claiming that it facilitated at least some of the misappropriation of PFG’s customer funds by Russell Wasendorf, Sr., the firm’s principal, that led to PFG’s bankruptcy in July 2012 and loss of more than US $215 million of customer funds.

  • NYS Financial Watchdog Imposes an Additional Fine on Bank of Tokyo-Mitsubishi UFJ for Misleading Regulators Regarding Prior Settlement: The New York State Department of Financial Services entered into a settlement with The Bank of Tokyo-Mitsubishi UFJ, Ltd., claiming that the bank misled it regarding its US dollar NY-based clearing services on behalf of US-sanctioned Sudanese, Iranian and Burmese parties from 2002 through 2007. The Department previously entered into a settlement with the bank related to these clearing services that required the bank to pay a fine of US $250 million and agree to other sanctions. In entering into this settlement, the Department relied on a report prepared by PricewaterhouseCoopers LLP that had been commissioned by the bank. However, the Department subsequently investigated PwC’s work and concluded that the bank “successfully convinced” the PwC engagement team to remove from its report certain adverse information about the bank. As a result, PwC was fined US $25 million by the Department and suspended from accepting certain consulting engagements at financial institutions overseen by the Department for a period of time. To resolve this current matter, the bank agreed to pay an additional fine of US $315 million, implement certain disciplinary measures against certain employees (including the former general manager of the bank’s anti-money laundering, compliance and legal division), and other sanctions. 

My View: My view hasn’t changed as I expressed it in a prior related article on this development: “With all respect to Shakespeare, ‘to include or not to include’ is really the important question these days for many professionals advising financial service firms or working within such entities in compliance or other control functions. Outside advisers engaged to issue reports to management regarding conduct that might be contrary to law, or internal staff required to author annual compliance or other control-oriented reports, must struggle between what they see, hear, and conclude, and how they write it, and the views of some management that may want a different emphasis in an official publication. These different perceptions can lead to tough discussions. In the end, however, a firm with a strong compliance culture will not seek to avoid accurate descriptions of facts being included in official documents no matter how embarrassing or how adverse the consequences of such disclosure may be.”

  • CME Group Fines Trader for Spoofing-Type Offense: Shlomi Salant agreed to pay a fine of US $30,000 and serve a 10-day trading suspension related to allegations by the Chicago Board of Trade that he engaged in spoofing-type activities at various times from September 2011 through December 2012. According to the CME Group, during this time, Mr. Salant on occasion placed orders to buy or sell a small quantity of 10-Year Note futures, and subsequently entered multiple large lot orders on the opposite side of his small order to “create an appearance of imbalance in the buy/sell pressure.” As soon as the small order began trading, claimed the CBoT, Mr. Salant cancelled his large orders. Mr. Salant was charged with violating various CBoT general offenses, including engaging “in conduct inconsistent with just and equitable principles of trade.” The facts at issue in this matter occurred prior to CME Group’s adoption of its recent disruptive trading practices rule (Rule 575).

  • Another CFTC Commissioner Recommends Amendments to Swaps Trade Execution Rules: Two weeks ago it was Commissioner J. Christopher Giancarlo, and last week it was Commissioner Mark Wetjen who suggested that the CFTC swaps trade execution regime “might be due for fine tuning.” In a speech before the Cumberland Lodge Financial Services Policy Summit in the United Kingdom, Mr. Wetjen recommended that the CFTC should not seek to impose its trading conditions on non-US multilateral trading facilities seeking exemption from registration as a swap execution facility solely to the extent transactions involve non-US persons. This should be the case, he argued, even if the platform also permits access by US persons. Such trading conditions should only be applied to transactions involving a US person, said Mr. Wetjen. Mr. Wetjen also recommended, among other things, that the CFTC should consider only requiring registration as a SEF trading platforms that facilitate trading in swaps subject to the Commission’s mandatory trading requirement and whether the currently available so-called "made available to trade" process should be replaced by an exclusive CFTC determination. According to Mr. Wetjen, “The existing policy is based on the assumption that SEFs and [designated contract market]s are best positioned to evaluate whether a swap is liquid enough to support a trading mandate. But independent regulatory agencies should not leave policymaking of this sort to the very commercial entities that stand to benefit most from the trading policies in question.”

My View: It appears timely for the CFTC to call for a meeting of its technology advisory committee or another public session to formally discuss possible amendments or other fixes to its trade execution rules.

  • Industry Organizations Request Basel Committee Reconsider Proposed Treatment of Segregated Customer Margin: A group of global trade associations and clearinghouses submitted a letter to the Basel Committee on Banking Supervision last week, arguing that the Basel III leverage ratio framework should not discourage centrally cleared transactions by penalizing banks that process customer margin through segregated accounts. (The group included FIA Global, The World Federation of Exchanges, CCP12, ICE, CME Group, LCH Clearnet Group and Eurex Group.) As a result, claims the group, BCBS should recognize that customer funds segregated by banks in support of cleared derivatives transactions cannot be leveraged by a bank, unlike customer collateral posted in support of non-cleared derivatives which can be leveraged. Without such recognition, banks will require more capital for their clearing business which will “likely result in market exit by some derivatives clearing members that will find the business no longer economically viable in terms of producing a sufficiently high return on equity,” claimed the group. The group recommends clarification of this principle through issuance of a Frequently Asked Questions document or an amendment to the leverage ratio.

And even more briefly:

  • CFTC to Discuss Position Limits Among Other Topics at December 9 Advisory Committee Meeting: Position limits and deliverable supplies and the agricultural economy will be the principal topics during a Commodity Futures Trading Commission agricultural advisory committee meeting to be held on December 9 at the CFTC offices in Washington, DC.

  • EnClear Proposes Futurization of Swaps Contracts During Last Weekend in November: LCH.Clearnet has proposed rulebook amendments to accommodate the transformation of most current EnClear Service swap contracts to block futures contracts during the weekend of November 29-30, 2014. Initially, LCH will use two exchanges for the registration of the block futures—Baltex (a multilateral trading facility operated by the Baltic Exchange Trading Limited) and Cleartrade Exchange (a Recognized Market Operator under the oversight of the Monetary Authority of Singapore).

  • FinCEN Revises List of FATF-Identified Jurisdictions With AML and Counterterrorist Financing Deficiencies: The Financial Crimes Enforcement Network of the US Department of Treasury has updated its list of jurisdictions with anti-money laundering and counterterrorist financing deficiencies. (Click here for additional information in the article “FinCEN Updates List of Jurisdictions With AML/CFT Deficiencies” in the November 21, 2014 edition of Corporate & Financial Weekly Digest by Katten Muchin Rosenman LLP.)

  • IOSCO Seeks Comments on CDS Post-Trade Transparency: The International Organization of Securities Commissions issued a report assessing the potential impact in the credit default swap market of mandatory post-trade transparency. Overall, IOSCO concluded “that greater post-trade transparency in the CDS market—including making the price and volume of individual transactions publicly available—would be valuable to market participants and other market observers.” Comments on IOSCO’s report may be made through February 15, 2015.

  • CFTC Reinstates NASDAQ Futures Inc. As a Designated Contract Market: The Commodity Futures Trading Commission reinstated the status of NASDAQ Futures Inc. as a designated contract market. The exchange was dormant as a contract market since January 1, 2014.

And finally:

  • Steak and Potatoes Please —But Hold the Insider Tips; Former Public Company CEO Charged With Passing Material Nonpublic Information to Favorite Restaurant Manager: The Securities and Exchange Commission filed a complaint in a federal court in New York against the former chief executive officer and member of the Board of Directors of GenTek, Inc., a public company, and the manager of one of his favorite restaurants related to insider trading of the company’s stock. According to the complaint, William Redmond, Jr. the former CEO, routinely discussed the pending acquisition of GenTek by American Securities LLC with Stefano Signorastri, the manager of the restaurant, prior to a public announcement about the acquisition. The SEC charged that Mr. Signorastri purchased GenTek stock based on this nonpublic information. Mr. Signorastri sold all his GenTek stock after the public announcement of the proposed acquisition for a profit of $164,260, said the SEC. According to a proposed settlement that must be approved by the court, Mr. Redmond will pay over US $240,000, representing the disgorgement of most of the profits of Mr. Signorastri and a penalty, while Mr. Signorastri will pay approximately $85,000 representing the remainder of the disgorgement and a penalty. Neither Mr. Redmond nor Mr. Signorastri will admit or deny the charges in the SEC’s complaint.

©2021 Katten Muchin Rosenman LLPNational Law Review, Volume IV, Number 329

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...