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Bridging the Week: October 13 to 17 and 20, 2014 (Marking the Close; CPO Delegation; Clearinghouse Recovery; To Tweet or Not to Tweet)

What should happen when clearinghouses and systemically important global financial institutions have to deal with financial abyss scenarios was the subject of a number of reports and a commentary this past week. Modern technology was also in the news relevant to the financial services industry as an algorithmic trading firm was fined by the Securities and Exchange Commission for marking the close, while a research analyst was penalized by the Financial Industry Regulatory Authority for not being fully transparent in connection with certain of his Twitter posts.

High-Frequency Trading Firm Pays US $1 Million for Serving Too Much “Gravy” on the Close From June to December 2009

Athena Capital Research, LLC, a New York City-based high-frequency trading firm, settled charges brought by the Securities and Exchange Commission for allegedly engaging in manipulative trading activities from June through December 2009 known as “marking the close.”

According to the SEC, Athena designed and employed computer algorithms—internally known as “Gravy”—that enabled it to make large purchases or sales of NASDAQ-listed stocks just prior to the exchange’s 4 p.m. close. These orders were placed each day after the exchange first publicized the net order imbalance in each stock 10 minutes prior to the end of trading. This indicator advised the market whether there were more buy orders than sell orders or more sell orders than buy orders for each stock and by how many shares.

Ordinarily the market price would be expected to move in the direction of the imbalance. For example, if the imbalance showed substantially more buy orders than sell orders, the market price would be expected to rise prior to the close, or fall, if there were more sell orders than buy orders.

The SEC claimed that, after learning of the imbalance, Athena would place a large imbalance-only-on-close order that was meant to take advantage of the perceived market conditions (for example, placing an order to sell securities when the imbalance reflected a predominance of buy orders). Athena then would execute orders in the opposite direction of its close order in the few seconds prior to the close (so-called “accumulation orders”), to improve its potential close order execution price, according to the Commission.

The majority of Athena’s accumulation orders were placed in the final two seconds of each trading each day, said the SEC, and the firm’s trades overall exceeded 70 percent of the total NASDAQ trading volume of relevant stocks just prior to the close.

Athena’s objective, charged the SEC, was for the price of its imbalance-only-on-close order fill to be superior to the average price of its accumulation orders executions and to be flat in each stock by the end of the day. According to an email by an Athena manager included by the SEC in its complaint,

[w]e have a desired accumulation pattern which includes grabbing stock at the beginning, a period of ‘average price’ accumulation, and a crescendo at the end.

Athena also modified its algorithm over time, claimed the SEC, to enhance its priority over other orders that might be placed on the close by other traders.

To settle the SEC’s complaint, without admitting or denying any of the Commissions findings, Athena agreed to pay a fine of US $1 million. The firm also agreed to be censured and committed not to violate the relevant provision of law and SEC regulation in the future. There were no requirements of disgorgement or any other trading prohibitions.

CFTC Makes Self-Executing and Expands Certain Relief Related to Delegating CPOs

The Commodity Futures Trading Commission made self-executing and somewhat expanded previously granted relief from registration requirements to commodity pool operators who delegate certain activities in connection with private investment funds.

In May 2014, the CFTC provided a streamlined process for CPOs to request registration relief when they delegated all of their management authority to another registered CPO (the so-called designated CPO) related to a commodity pool. However, where the delegating CPO was a natural person of the designated CPO—for example, a director—the individual had to agree to joint and several liability with the designated CPO. Also, among other limitations, the delegating CPO could not engage in sales activities for the fund that he/she served as a director. (Click here for the article regarding this process in “CFTC Implements Streamlined Way for Certain CPOs to Apply for Registration Relief” in the May 13, 2014 edition ofBetween Bridges.)

Under the new requirements set forth by the Commission's Division of Swap Dealer and Intermediary Oversight, registration relief does not need to be requested if all enumerated conditions are met. Among these conditions are that:

  1. through a legally binding document, the delegating CPO delegated its investment management authority regarding the relevant commodity pool to the designated CPO (although the delegating or designated CPO may also appoint certain third parties to serve as investment managers of the pool—either registered commodity trading advisors or persons lawfully exempt from CTA registration);

  2. the delegating CPO is not involved in the solicitation of participants for the relevant commodity pool (although he/she may engage in solicitation activities solely in his/her role as an associated person of the designated CPO provided he/she is registered as an AP of the designated CPO or lawfully exempt from AP registration);

  3. the delegating CPO is not involved in the management of any property of the relevant pool (although he/she may have management responsibilities over pool property under limited, enumerated circumstances where he/she is a principal or employee of the designated CPO or of a CTA of the relevant pool);

  4. the designated CPO is a registered CPO;

  5. the delegating CPO is not subject to any statutory disqualification;

  6. there is a “business purpose” for the designated CPO to be a separate entity from the delegating CPO other than for the delegating CPO to avoid registration;

  7. the designated CPO maintains the books and records of the delegating CPO; and

  8. if the delegating CPO is a natural person and affiliated with the commodity pool, the delegating and designated CPO have signed a legally binding agreement to be jointly and severally liable for violations under applicable law or regulations by the other in connection with the operation of the pool.

In articulating its new requirements, Commission staff acknowledged that “there may be other CPO delegation situations involving circumstances in which CPO registration no-action relief may be warranted.” Staff indicated it would continue to evaluate such circumstances in response to requests submitted to it.

My View: The CFTC’s new requirements related to the delegation of management authority by directors of private commodity funds to avoid registration requirements are a good first practical step to address a CFTC view that where a fund is structured as a limited partnership and has many general partners, each general partner may be a CPO and obligated to register as such, and where a fund is structured as a corporation, trust or limited liability company with a board of directors, each director may also be deemed a CPO and required to register accordingly too. The next step is to begin rule-making—as recommended in a July 30, 2014 letter from the Managed Futures Association to Chairman Timothy Massad—to make clear that such general partners and directors are not required to register as CPOs in the first instance, and if subject to conditions, that one is not exposing directors of private investment funds to potential liability for their ordinary conduct as directors when they have not engaged in any misconduct.

And briefly:

  • Investment Advisor Compliance Officer Charged by SEC for Altering Document Related to Insider Trading Probe: The Securities and Exchange Commission has commenced an administrative action against Judy Wolf, a former compliance consultant to Wells Fargo Advisors, LLC, alleging that she altered a document that summarized her review of certain trading by a former WF Advisors employee, prior to submitting it to the SEC. The SEC had requested the document in connection with an insider trading probe of WF Advisors after taking legal action against the former employee, Waldyr Da Silva Prado Neto, in September 2012. The SEC alleged that Mr. Neto traded Burger King stock based on illegally acquired non-public information. According to the SEC, Ms. Wolf first summarized her review of Mr. Prado’s trading in September 2012. At the time, she made no findings. In December 2012, after the SEC commenced its case against Mr. Prado, Ms. Wolf amended her report to reflect “a more thorough review than she actually did in September 2010,” claimed the Commission. WF Advisors produced this amended, not the original, document when requested by the SEC. WF Advisors had previously agreed to pay a fine of US $5 million in connection with charges brought by the SEC for not having adequate controls to prevent Mr. Prado to trade on insider information and for providing the altered document. Mr. Prado has been ordered by a federal court to pay over US $5 million in penalties for his misconduct, and has been barred from registering in the securities industry in any capacity.

  • CPMI/IOSCO Advises Clearinghouses How to Recover From Threats to Their Viability: Two international regulatory organizations have made recommendations on how clearinghouses and other so-called “financial market infrastructures” (FMIs) should plan to recover from market disruption events that might imperil their existence. The organizations are the Committee on Payments and Market Infrastructures of the Bank for International Settlements and the International Organization of Securities Commissions. According to the regulatory organizations, all FMIs should have a “comprehensive and effective recovery plan” that includes rules-based mechanisms to “allocate any uncovered losses and cover liquidity shortfalls”—whether they are caused by a participant’s default or otherwise. In addition, all FMIs should have the capability to replenish their financial resources “in order to continue to provide critical services,” while clearinghouses should also be able to reinstate a matched book. To recover from financial losses, the regulatory organizations recommend that FMIs “consider having explicit insurance or indemnity agreements” as a backstop to having sufficient capital and a “viable plan to recapitalize” in the first place. Clearinghouses’ capability to address position imbalances may derive through incentives to various participants, but the regulatory organizations caution that a clearinghouse “should also have a mandatory, … agreed mechanism to re-establish a matched book in case such voluntary efforts fail.” The regulatory organzations also argue that FMIs should have the ability to absorb losses resulting from business operations, and not pass on such losses to participants. According to the regulatory organization, "[a]llocation of such losses should begin with the premise that the losses are first charged against the FMI's capital, i.e., they should be borne in the first instance by the owners of the FMI." Finally, the regulatory organizations stress that resolution processes should be “transparent and allow those who would bear losses and liquidity shortfalls to measure, manage and control their potential exposure.”

  • PIMCO Offers Views on the Protection of Client Funds at Clearinghouses: PIMCO—one of the largest global investment management firms with over US $1.87 trillion in assets under management (as of September 30)—published its own recommendations last week to help avoid a clearinghouse collapse. Among other recommendations are that clearinghouses should increase their own contribution to guaranty funds to the higher of 5 percent of the guaranty fund, US $20 million or the third-largest clearing member contribution, and that this contribution should be fully funded in advance. PIMCO also recommends that (1) clearinghouses should be subject to periodic stress tests approved and reviewed by regulators and have access to central banks for cash deposits and for repurchase agreements for securities (in order to help ensure a clearinghouse’s liquidity in a time of market stress), and (2) if a clearing member fails, client assets should only be utilized as a last resort—after clearinghouse and defaulting members’ “contributions” have been completely used up. The investment manager also argues that the current protective regime in the US for cleared swaps customer funds should be extended to futures. Currently, the rules around cleared swaps customer funds are more stringent in the US than those for futures customer funds.

  • ​FSB Advises Regulators How to Oversee Resolution of Failed Financial Institutions: The Financial Stability Board has issued a report setting forth “twelve essential features” that should be part of the resolution scheme of each jurisdiction to help minimize the impact of a collapsing financial institution. According to FSB, “[t]he objective of an effective resolution regime is to make feasible the resolution of financial institutions without severe systemic disruption and without exposing taxpayers to loss, while protecting vital economic functions through mechanisms which make it possible for shareholders and unsecured and uninsured creditors to absorb losses in a manner that respects the hierarchy of claims in liquidation.” Among the most important attributes of an effective resolution regime, claims FSB, is that all domestically incorporated systemically important financial entities should be (1) required to maintain a recovery and resolution plan (including at the group level) with certain enumerated “essential elements;” (2) subject to regular “resolvability assessments” to assesses the realism of their resolution strategies; and (3) covered by institution-specific cross-border cooperation agreements between home and relevant host regulators. Separately, FSB issued consultative guidance for cooperation and information sharing for regulators of jurisdictions that host operations of a systemically important financial institution but are not among the regulators overseeing such entity that comprise a crisis management group. Comments are due by December 1.

  • Research Analyst Tweeter Is Fined by FINRA for Not Tweeting About Personal Stock Holdings: Jon Hickman, a former research analyst with MDB Capital Group LLC, was fined by the Financial Industry Regulatory Authority for making recommendations about certain equity securities through Twitter posts without disclosing that he owned such stocks. As a result, FINRA claimed his recommendations were not fair or balanced and failed to provide sufficient facts for his Twitter followers to evaluate his advice. Mr. Hickman allegedly made recommendations through his Twitter account from April 29, 2009, through June 14, 2011, without the knowledge of his firm. During that time, Mr. Hickman made recommendations regarding seven securities that he discussed in 11 Twitter posts, said FINRA. To resolve this matter, Mr. Hickman agreed to a 10-day suspension from associating with any FINRA member and payment of a US $15,000 fine.

And even more briefly:

  • Priorities Emerge in SEC Enforcement’s Look Back at 2014 Activities: The Securities and Exchange Commission issued a press release extolling its enforcement accomplishments during its just-ended fiscal year 2014. Among other milestones, the SEC noted its first ever cases under its recently adopted market access rule and prohibition against whistleblower retaliation. Overall, in the fiscal year ending 2014, the SEC brought 755 enforcement actions, obtaining orders for over $4 billion in penalties and disgorgement.

Compliance Weeds: Although it is easy to view a regulator’s report of its enforcement accomplishments with a bit of cynicism, such reports are very useful summaries of a regulator’s priorities and should be used as checklists to help registrants double check their policies and procedures to ensure they are adequately addressing a regulator’s principal concerns. Some regulators, like the SEC, also periodically publish enforcement priorities and examination guides. (Click here, for example, to see the article “SEC Begins Assessment of Broker Dealers’ Cyber Security Preparedness,” in the April 14 to 18 and 21 edition of Bridging the Week.) These documents too should be carefully perused to conduct gap analyses between a firm’s existing policies and practices, and the current expectations of the regulator.

  • CFTC Extends to December 31 Date by Which FCMs Must Obtain Form Acknowledgement Letters From Certain Foreign Depositories When Fault Is CFTC’s: The Commodity Futures Trading Commission has extended to December 31 the date by which futures commission merchants must obtain required form acknowledgement letters from certain depositories. Relevant depositories are those that have not yet entered into a standard online access agreement with the CFTC. The CFTC had previously extended this deadline date to October 17.

  • LME to Be Gold Standard for Platinum and Palladium Price Fixing: The London Metal Exchange was appointed as the new provider of twice-daily benchmark platinum and palladium prices. The LME will provide this service beginning December 1. The London Platinum and Palladium Fixing Company Limited—the company that currently overseas daily platinum and palladium price fixings—appointed the exchange to this role.

©2022 Katten Muchin Rosenman LLPNational Law Review, Volume IV, Number 293

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...