June 21, 2021

Volume XI, Number 172

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June 18, 2021

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Bridging the Week: October 10 to 14 and October 17, 2016 (Coming to the US; Cross-Border; Liquidity Management; Insider Trading Supervision)

Navinder Sarao will likely soon be headed to the United States to stand trial in connection with criminal charges against him for his alleged role in the May 2010 “Flash Crash” after losing his last effort to avoid extradition from his home in the United Kingdom. In addition, non-US consolidated subsidiaries of US entities might more readily have to register as swap dealers under proposed new cross-border rules by the Commodity Futures Trading Commission, while the Securities and Exchange Commission issued final rules to purportedly strengthen the liquidity risk management of open-end investment funds. As a result, the following matters are covered in this week’s edition of Bridging the Week:

  • Alleged Flash Crasher Navinder Sarao Loses Final Effort to Avoid US Extradition (includes Legal Weeds);

  • CFTC Requires All Non-US Consolidated Subsidiaries of US Parents to Count All Swaps in De Minimis Threshold in Proposed Cross-Border Rules (includes My View and Legal Weeds);

  • SEC Imposes Tougher Liquidity Requirements on Mutual Funds; Defers Decision on Derivatives;

  • Just Calling Sam Is Inadequate Substitute for Robust AML Procedures Even at Small Broker-Dealer Rules FINRA Adjudicatory Council (includes Compliance Weeds and Culture and Ethics);

  • Investment Adviser and Supervisor Resolve SEC Charges They Failed to Supervise Employee Who Engaged in Insider Trading;

  • COMEX and NYMEX Should Increase Testing of Position Limits Exemptions Says CFTC in Rule Review (includes My View);

  • Federal Court Finds No Possible Manipulation of US Treasury Markets Where No Allegation of Intent (includes Legal Weeds); and more.

Briefly:

  • Alleged Flash Crasher Navinder Sarao Loses Final Effort to Avoid US Extradition: Navinder Sarao, the London-based futures trader who in April 2015 was criminally charged with contributing to the May 2010 “Flash Crash,” is now less than 28 days away from likely being extradited from his home abroad to the United States to stand trial. This is the result of a decision last Friday by two justices of the UK’s High Court denying Mr. Sarao permission to challenge a prior extradition order. Previously, another UK court found that the offenses for which Mr. Sarao was indicted in the United States – spoofing and engaging in manipulative conduct – would be prosecutable in the United Kingdom, albeit under different laws and thus his involuntary transfer to the United States was warranted. In April 2o15, Mr. Sarao was also subject to civil charges brought by the Commodity Futures Trading Commission. The CFTC charged Mr. Sarao and his trading company, Nav Sarao Futures Limited PLC, with engaging in spoofing involving E-mini S&P futures contracts traded on the Chicago Mercantile Exchange for the purpose of disrupting the market in order to facilitate related trading that netted him profits in excess of US $40 million. The alleged wrongful trading occurred between April 2010 and April 2015. In addition, the two defendants were charged by the CFTC with manipulation, attempted manipulation and employing manipulative or deceptive devices or contrivances. The “Flash Crash” refers to events on May 6, 2010, 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.

Legal Weeds: Earlier this year Michael Coscia was sentenced to three years’ imprisonment for illicit futures trading he engaged in during three months in 2011. Like Mr. Sarao currently, Mr. Coscia had been criminally charged for violating the law prohibiting spoofing that was enacted after the 2007-2008 financial crisis. (Click here to access Commodity Exchange Act Section 4c(a)(5)(C), 7 US Code § 6c(a)(5)(C).) Previously, Mr. Coscia had settled civil actions related to the same conduct with the CFTC, the Financial Conduct Authority and the CME Group by payments of aggregate fines of approximately US $3.1 million; disgorgement of profits; and a one-year trading suspension. Mr. Coscia was convicted of six counts of commodities fraud and six counts of spoofing for his prohibited trading activities in November 2015. 

  • CFTC Requires All Non-US Consolidated Subsidiaries of US Parents to Count All Swaps in De Minimis Threshold in Proposed Cross-Border Rules: The Commodity Futures Trading Commission proposed rules regarding the application of certain of its swaps requirements, including registration, in connection with cross-border transactions. Among other provisions, the CFTC proposed that all non-US persons that are consolidated for accounting purposes with a US entity (Foreign Consolidated Subsidiary or FCS) be required to count all swaps opposite US persons and non-US persons in determining whether they exceed the so-called de minimis threshold that would trigger their registration as a swap dealer. However, the CFTC also proposed that only non-natural persons organized or incorporated in the United States or that have their principal places of business in the United States (including any branch) would constitute US persons under its new proposal. The CFTC expressly noted that its proposed definition would “not include a commodity pooled account, pooled account, investment fund or other collective investment vehicle that is majority-owned by one or more US persons” unless the investment vehicle met the new proposed territorial requirements. The CFTC also proposed that when a non-US swap dealer uses US persons to arrange, negotiate or execute a swap (ANE Transaction) that, if executed, would be booked outside the United States, such transactions would be subject to the CFTC’s anti-fraud and anti-manipulation rules as well as obligations to communicate in a fair and reasonable manner. ANE Transactions, opined the CFTC, will include activities “normally associated with sales and trading, as opposed to internal back-office activities, such as ministerial or clerical tasks performed by personnel not involved in the actual sale or trading of the relevant swap.” The CFTC will accept comments for 60 after publication of its proposed rules in the Federal Register. (Click here for additional details regarding the CFTC proposal.)

My View: The CFTC’s proposed cross-border rules regarding application of certain of its swap requirements contains at least one potentially deleterious expansion and one potential improvement over its 2013 Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations. The bad provision is the proposal that all FCSs – even if non-guaranteed or bankruptcy remote from their ultimate parent company – must count all swaps with US and non-US persons in determining their potential registration requirement as a swap dealer. Moreover, a non-US person would have to include a bilateral swap opposite an FCS in its own threshold calculation to assess its own potential registration requirement. This could dissuade non-US persons from engaging in swaps with FCSs. On the other hand, by defining a bright light territorial test to assess whether an investment vehicle is a US person, non-US persons might be inclined to engage in more swaps with non-US-based investment vehicles since they will not have to worry about such swaps causing them potential US swap dealer registration headaches.

Legal Weeds: In September 2014, a US federal court mostly tossed out all legal challenges brought by three industry groups to the CFTC’s 2013 Interpretive Guidance. In ruling generally against the plaintiffs, the court adopted the CFTC’s principal argument, that the Dodd-Frank Wall Street Reform and Consumer Protection Act’s swaps requirements applied extraterritorially when swaps activity outside the United States had a “direct and significant connection” with US commerce without the need for any implementing regulations. As a result, the court said, “[t]he CFTC was not required to issue any guidance (let alone binding rule) regarding its intended enforcement policies. … Indeed, the CFTC’s decision to provide such a non-binding policy statement benefits market participants and cannot now, all other things being equal, be turned against it.” Notwithstanding, the court ordered the CFTC to conduct a cost-benefit analysis regarding the extraterritorial application of many of the CFTC’s rules addressed in the cross-border guidance. In response, the CFTC sought comment on its cross-border guidance in March 2015. The current proposed rules incorporate the CFTC’s response to that input.

  • SEC Imposes Tougher Liquidity Requirements on Mutual Funds; Defers Decision on Derivatives: The Securities and Exchange Commission approved final rules aimed at enhancing liquidity risk management by open-end investment funds and increasing the reporting and disclosure obligations of registered investment companies. Under the SEC’s new rules, impacted funds will be required to assess, manage and periodically review their liquidity risk based on enumerated factors to minimize the likelihood that they could not meet requests to redeem shares without detrimentally impacting remaining shareholders. In addition, impacted funds would be required to decide a minimum percentage of their net assets that they would have to maintain in highly liquid assets (i.e., cash or investments that could reasonably be expected to be liquidated in three business days or less without significantly deteriorating their market value) and cap its holding of illiquid assets to 15 percent of its overall assets (i.e., investments that could not reasonably be expected to be liquidated in current market conditions within seven calendar dates without significantly deteriorating their market value). Open-end management investment companies would be required to disclose on their registration forms their procedures for redeeming fund shares, the number of days reasonably expected to pay redemption proceeds and the method for meeting redemption requests, and on reporting forms, information regarding the aggregated percentage of their portfolios representing each of four ease of salability classification categories and information on the use of lines of credit and inter-fund borrowing and lending. The SEC also proposed rules permitting funds to pass along costs incurred in meeting redemption requests (i.e., swing pricing). The SEC deferred adopting final rules related to the use of derivatives by funds. Different final rules have different compliance dates, with the largest funds being required to comply with the liquidity management rules by December 1, 2018.

  • Just Calling Sam Is Inadequate Substitute for Robust AML Procedures Even at Small Broker-Dealer Rules FINRA Adjudicatory Council: A decision by the Financial Industry Regulation Authority to fine Lek Securities Corporation, a registered broker-dealer, US $100,000 for failing to establish and implement adequate anti-money laundering procedures was upheld by the National Adjudicatory Council – a FINRA committee that reviews initial decisions from disciplinary and membership proceedings. A FINRA panel found after a hearing in 2014, that from January 1, 2008, through October 31, 2010, Lek Securities’s AML procedures were inadequate because they “contained little guidance with regard to manipulative trading that might require the filing of a suspicious activity report.” Instead, its AML procedures predominantly focused on money movement issues. Moreover, during one-half of the relevant time, said the NAC in affirming the FINRA panel’s decision, Lek Securities “had no specific automated exception report for potentially manipulative trading.” Instead, noted the NAC, the majority owner of Lek Securities, Samuel Lek, expected that most serious issues would be identified by the firm’s small staff (approximately 20) and brought to his attention. According to Mr. Lek’s testimony, “[t]he written supervisory procedures are not a description of exactly what in a 20-man firm everybody should do other than call Sam. That’s – that’s the general thing, let Sam know.” As a result, the NAC upheld the FINRA panel’s conclusion that Lek Securities’s AML policies were not reasonably designed for their purpose and that the firm improperly delegated some of its AML obligations to an introducing firm. The NAC also assessed Lek Securities approximately $16,500 in costs for the appeal.

Compliance Weeds: Applicable law and rules of the Financial Crimes Enforcement Network of the US Department of Treasury require broker-dealers and other covered financial institutions (banks, Commodity Futures Trading Commission-registered future commission merchants and introducing brokers and SEC-registered mutual funds) to file a suspicious activities report (SAR) with FinCEN in response to transactions or patterns of transactions involving at least US $5,000 which a covered entity “knows, suspects, or has reason to suspect” involve funds derived from illegal activity; have no business or apparent lawful purpose; are designed to evade applicable law; or utilize the institution for criminal activity. In spring 2016, Albert Fried & Company, LLC, a registered broker-dealer, agreed to pay a fine of US $300,000 to resolve charges by the Securities and Exchange Commission that, from August 2010 through October 2015, it failed to file SARs by customers with FinCEN, as required by law. Previously, FINRA fined Brown Brothers Harriman & Co. US $8 million for failing to file SARs in connection with similar activity involving penny stocks. In that matter, FINRA also fined and suspended the firm’s global anti-money laundering compliance officer for his alleged role in the firm’s alleged misconduct. Covered entities should continually monitor transactions they effectuate and ensure they maintain written procedures they follow to identify and evaluate red flags of suspicious activities and file required SARs with FinCEN when appropriate. (Click here for a discussion of another FINRA disciplinary action against a member for alleged widespread AML breakdowns.)

Culture and Ethics: Sam tried to keep it simple. And perhaps, in a former day, his method of supervision might have been more appreciated. Unfortunately, today, it is unlikely that just a few surveillance systems, an astute and observant small staff, and just calling Sam are sufficient to meet minimum regulatory expectations for reasonable supervision particularly, as in the case of Lek Securities, where the client base generated 500 trades/minutes. However, Sam tried to keep it simple, and focusing employees on a few high level objectives in addition to the myriad of rules that likely govern their business, is very important to ensuring that a strong compliance culture is ingrained within the DNA of an organization. These days, however, employees need to abide by both high level objectives and detailed rules (memorialized in robust written procedures and training), and have strong automated surveillance systems tailored to a firm's precise business for a registered entity to satisfy the minimum expectations of regulators. 

  • Investment Adviser and Supervisor Resolve SEC Charges They Failed to Supervise Employee Who Engaged in Insider Trading: Artis Capital Management LP, a registered investment adviser, and Michael Harden, a senior analyst at Artis, settled charges brought by the Securities and Exchange Commission that they failed reasonably to supervise Matthew Teeple, an analyst at Artis, who, on at least two occasions in 2008, illicitly obtained insider information regarding Foundry Networks, Inc., a publicly traded company. The SEC charged that Artis relied on this information in making trading decisions for Artis-managed hedge funds. The SEC noted that, unlike an ordinary analyst, Mr. Teeple worked from home, did not use analytic models for his trading recommendations and did not provide written reports regarding his views. As a result, the SEC claimed, Mr. Harden should have been suspicious when Mr. Teeple made recommendations to buy Foundry in July 2008, and five days later Foundry announced it would merge with a third party. According to the SEC, Mr. Harden also failed to question another recommendation regarding Foundry by Mr. Teeple in October 28 followed by predicted corporative activity. Among other things, Mr. Foundry, in response, did not consult with Artis’s chief compliance officer as required by Artis’s policies, charged the SEC. As a result of trading on the alleged insider information forwarded by Mr. Teeple, Artis achieved profits and avoided losses of approximately $25.3 million, and achieved other income of approximately $5.17 million (e.g., through management agreements with the funds). To resolve this matter, Artis agreed to pay a total penalty of almost US $9 million, including almost US $5.17 million in disgorgement, while Mr. Harden agreed to pay a fine of US $130,000. Mr. Teeple previously settled civil and criminal charges related to his conduct.

  • COMEX and NYMEX Should Increase Testing of Position Limits Exemptions Says CFTC in Rule Review: The New York Mercantile Exchange and the Commodity Exchange should consider adopting a formal review process to confirm that market participants are using approved strategies when relying on an exemption from an exchange-granted position limit, said Commodity Futures Trading staff in a rule review of the two exchange’s compliance with certain of the core responsibilities of designated contract markets. In general, staff of the CFTC’s Division of Market Oversight concluded that NYMEX and COMEX maintained an adequate surveillance program for routine surveillance of market trading and expiring contracts; had adequate surveillance tools and staffing; and that the exchanges’ investigative work was “thorough and complete.” The CFTC did not review the exchanges’ handling of exchange for related position transactions as part of its review, but indicated that a separate review on EFRPs was currently underway. DSIO staff indicated that the exchanges’ use of warning letters to resolve certain violations was “appropriate.” In those instances, the exchanges’ market surveillance (MS) staff had concluded that the relevant cases “typically involved simple administrative or clerical errors and very low overages, which MS determined did not disrupt the market or unduly impact settlements of contracts.”

My View: I recently reported on a rule review by the CFTC’s DMO of the CBOE Futures Exchange, LLC. One recommendation made by staff was that the CBOE Futures Regulation Department “should recommend and the Exchange should promptly take appropriate disciplinary action when it makes a finding that a violation of a substantive trading rule occurred.” This may sound innocuous. However, the recommendation was made in response to the issuance of warning letters by CFE to certain trading permit holders in response to their alleged placement of fictitious orders and trades. According to CFTC staff, “[w]hile a warning letter may be appropriate for certain violations of recordkeeping or audit trail rules, the Division believes that issuing a warning letter for a substantive trading violation is never appropriate.” As I have written previously, this statement appears contrary to the plain language of CFTC Rule 38.711 (click here to access) that does not limit the types of violations for which warning letters may be issued. All this provision does is limit to one time the number of occasions an exchange may issue a warning letter for any type of rule violation during a rolling one-year period. If, based on its own assessment of facts and circumstances, an exchange believes that the appropriate disciplinary action in response to a rule violation is to issue a warning letter, the CFTC should defer to the exchange’s discretion absent extraordinary circumstances. It is encouraging that CFTC staff may have backed away from its harsh and seeming misinterpretation of the relevant CFTC rule in DMO’s NYMEX and COMEX rule review.

  • Federal Court Finds No Possible Manipulation of US Treasury Markets Where No Allegation of Intent: A US federal court in Chicago dismissed a lawsuit against anonymous “John Doe” defendants that claimed the defendants engaged in spoofing-type trading activities of US Treasury markets that constituted manipulation under the anti-fraud provisions of applicable securities laws and relevant regulations promulgated by the Securities and Exchange Commission. (Click here to access Section 10(b) of the Securities Exchange Act of 1934, 15 USC §78j(b) and here to access SEC rules 10b-5(a) and (c).) According to a lawsuit filed by CP Stone Fort Holdings, LLC, the defendants manipulated the US Treasury markets by submitting orders to various trading platforms (i.e., BrokerTech and eSpeed) that they never intended to be executed. The complaint alleged defendants placed orders on one side of the market “to create the false appearance of market demand,” then pulled the order, and placed orders on the opposite side of the market to achieve execution. However, the court held that plaintiff’s complaint was deficient as it failed to state, with respect to each alleged act or omission by defendants, particular facts “giving rise to a strong inference[e]” that the defendants acted with an intent to deceive, manipulate or defraud. Such statement is required for a complaint to go forward under the relevant anti-fraud provisions  said the court. All the plaintiff pleaded, noted the court, was that defendants placed orders that they later cancelled and, “as plaintiff must admit, there is nothing improper or illegitimate about placing passive orders in the order book and then reversing position.” Among other things, the complaint failed to allege "how many orders were executed, how long the ultimately cancelled orders had remained resting and available for execution prior to cancellation, or whether the platform rules required the orders to be exposed further." The court observed that plaintiff’s complaint was “devoid of any allegation” that the defendants refused to execute any submitted order. As a result, concluded the court, because the plaintiff failed to allege illegal manipulation it also failed to allege the “strong inference” of scienter necessary to sustain its complaint.

Legal Weeds: The key phrase of Section 10(b) of the Securities Exchange Act of 1934 “manipulative or deceptive device or contrivance” is also at the heart of the relatively new parallel provision of the Commodities Exchange Act, Section 6(c)(1) enacted after the 2008/2009 financial crisis (click here to access this provision, 7 US Code § 9(1)). Pursuant to this CEA authority, the CFTC adopted Rule 180.1 (click here to access), and has used this law and rule in a wide-ranging host of enforcement actions, from its proceeding against JP Morgan in the so-called “London Whale” incident, to allegations of illegal off-exchange metals transactions, insider trading, claims of more traditional manipulation and attempted manipulation (without endeavoring to show an artificial price) and allegations of spoofing. In adopting Rule 180.1, the CFTC indicated that it would be guided “but not controlled” by the substantial body of judicial precedent applying the comparable language of SEC Rule 10b-5. (Click here to access CFTC insight on its Rule 180.1.; click here for a discussion of the CFTC’s use of its Rule 180.1.)

And more briefly:

  • CFTC Formally Delays Swap Dealer De Minimis Threshold Decrease: The Commodity Futures Trading Commission formally extended for one year the current US $8 billion de minimis threshold that would trigger a swap dealer registration requirement. Currently, if a person engages in certain swaps with a gross notional amount in excess of $8 billion during the prior 12-month period it must register as an SD; this amount was automatically scheduled to reduce at the end of 2017. The CFTC action delays this reduction until the end of 2018 so the agency can further study the impact of any change in the threshold amount. (Click here for further information on the de minimis threshold.)

  • Nonmember Fined US $100,000 and Access Ban by CME Group for Prearranged Trading to Transfer Equity: A business conduct committee panel of the Chicago Board of Trade order that Yong Zhang, a nonmember, pay a fine of US $100,000 for engaging in 96 trades of soybean futures contracts from October 8 through November 8, 2012 to transfer equity between two accounts he controlled. One account was the account of Mr. Zhang’s employer, while the other account was that of another nonmember. The panel also ordered Mr. Zhang to pay approximately US $31,000 in restitution and be prohibited from accessing any CME Group exchange for trading or membership.

  • SEC Applauds Itself on Most Ever Enforcement Cases in Fiscal Year 2016: The Securities and Exchange Commission summarized that it had filed 868 enforcement actions in its 2016 fiscal year that just ended on September 30 and obtained aggregate judgments and orders in excess of US $4 billion in fines and disgorgement. This number of actions was a “single year high” said the SEC.

  • Investment Bank Resolves SEC Charges It Failed to Safeguard Nonpublic Research Information: Deutsche Bank Securities Inc., a registered broker-dealer, agreed to pay a fine of US $9.5 million to resolve charges brought by the Securities and Exchange Commission that, from at least January 2012 through December 2014, it failed to have and enforce policies and procedures that were reasonably designed to prevent its equity research analysts for misusing nonpublic information contained in their unpublished views and analyses that later appeared in the firm’s research reports. The SEC said that, as a result, during the relevant time, DBSI, on a few occasions, did not stop its research analysts from sharing their views regarding potentially market sensitive information with customers and DBSI sales personnel in advance of a formal dissemination. The SEC also charged DBSI with a violation of its analyst certification rule (Click here to access the relevant provision of SEC Regulation AC) when, on March 29, 2012, it published a buy recommendation by Charles Grom, one of its analysts, who certified that the recommendation reflected his personal view, when in fact it did not. Mr. Grom previously was sued by the SEC for this alleged violation. 

  • HK SFC Commences Review of Brokers’ Internet and Mobile Trading Systems: The Hong Kong Securities and Futures Commission announced it began a focused review to assess “the cybersecurity preparedness, compliance and resilience of brokers’ internet/mobile trading systems.” SFC claimed this sweep was initiated by reports that an increasing number of such systems have been compromised. The SFC anticipates using the results of its review to develop its cybersecurity policy.

©2021 Katten Muchin Rosenman LLPNational Law Review, Volume VI, Number 291
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About this Author

Gary DeWaal, Securities Attorney, Katten Law Firm, New York
Special Counsel

Gary DeWaal focuses his practice on financial services regulatory matters. He counsels clients on the application of evolving regulatory requirements to existing businesses and structuring more effective compliance programs, as well as assists in defending and resolving regulatory disciplinary actions and enforcement matters. Gary also advises buy-side and sell-side clients, as well as trading facilities and clearing houses, on the developing laws and regulations related to cryptocurrencies and digital tokens.

Previously, Gary was a senior...

212-940-6558
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