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Bridging the Week: Spoofing; Physical Position Reporting; Administrative Proceedings; Blue Sheets; Reg AT; Order Handling Disclosure; Hedge Exemptions

Last week, Michael Coscia, the first individual prosecuted and convicted under the provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act that prohibits spoofing, was sentenced to three years in prison. Meanwhile, committee members and witnesses appearing before the House Committee on Agriculture’s hearing on the Commodity Futures Trading Commission proposed Regulation Automated Trading attacked the proposal’s requirements related to source code and registration while commentators also criticized in writing many aspects of the CFTC’s recently proposed amendments regarding non-enumerated hedge exemptions to its November 2013 position limits rules proposals. This was despite generally supporting the agency’s willingness to permit exchanges to grant such exemptions in the first instance. As a result, the following matters are covered in this week’s edition of Bridging the Week:

  • Michael Coscia Sentenced to Three Years’ Imprisonment for Spoofing and Commodity Fraud (includes My View):

  • Two Foreign Agribusinesses Agree to Resolve CFTC Charges for Their Alleged Failure to Report Physical Positions (includes Compliance Weeds and My View);

  • SEC Amends Rules of Practice for Administrative Proceedings to Make More Court-Like;

  • Computer Coding Error Results in Broker-Dealer Blue Sheets’ Errors Over 15 Years and US $7 Million SEC Fine (includes Compliance Weeds);

  • Speakers Attack Source Code and Registration Provisions of Proposed Reg AT Before Congressional Committee (includes My View);

  • Enhancement of Broker-Dealer Disclosure Obligations Regarding Customer Order Handling Goal of SEC Proposed New Rules;

  • Introducing Broker Settles CFTC Action for Solicitation Fraud and Lying to NFA;

  • Industry Participants Generally Applaud Proposed Amendments to CFTC Position Limit Proposal But Criticize Ability to Undo Exchanges’ Determinations; and more.

Video Version:

Michael Coscia Sentenced to Three Years’ Imprisonment for Spoofing and Commodity Fraud:

Michael Coscia, the first person prosecuted and convicted under a law prohibiting spoofing that was enacted after the 2007-2008 financial crisis, was sentenced to three years’ imprisonment last week for illicit futures trading he engaged in during three months in 2011.

In July 2013, Mr. Coscia settled civil actions related to the same conduct with the Commodity Futures Trading Commission, 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. (Click here for details of Mr. Coscia's conviction.)

Leading up to the sentencing, the United States Attorney’s Office in Chicago had requested that the judge presiding over Mr. Coscia’s criminal trial impose the maximum sentence recommended by applicable guidelines of between 70 and 87 months in prison, while Mr. Coscia’s counsel had argued for a lesser term of between no more than 4 to 10 months’ imprisonment. (Click here for details.) It appears likely that Mr. Coscia will appeal his conviction.

Separately, the Chicago-based federal judge hearing the CFTC’s enforcement action against a trader and his company for alleged spoofing through posting and flipping trading conduct denied the agency’s request for preliminary injunction, saying that surveillance reports and compliance tools already put in place by the defendants, as well as certain additional trading restrictions imposed by the judge herself, would restrict the defendants’ capability to engage in any potentially prohibited spoofing-type trading activities. As a result, said the judge, “a preliminary injunction is inappropriate at this time.”

Under the judge’s order, the trading firm’s chief compliance officer is obligated to file a sworn affidavit with the court every month between now and the conclusion of the relevant trial “affirming that all of [the enumerated] trading restrictions and compliance tools remain in place and that neither [of the defendants] have violated any of them.” (Click here for background on this enforcement action in the article, “CFTC Enforcement Action Introduces New Theory of Spoofing” in the October 25, 2013 edition of Bridging the Week.)

My View: It seems somewhat draconian that Mr. Coscia was sentenced to three years in prison for violating a new law for which he already paid substantial civil sanctions; which on its face appears to prohibit at least some legitimate trading practices; and which may not have given him adequate notice of prohibited conduct. Recently, in announcing its issuance of its first cross-market equities report cards aimed at helping member firms identify potential spoofing and layering activity, the Financial Industry Regulatory Authority defined spoofing as “entering orders to entice other participants to join on the same side of the market at a price at which they would not ordinarily trade, and then trading against the other market participants’ orders.” This is a comprehensive practical definition. Contrariwise, the relevant provision under which Mr. Coscia was convicted prohibits “spoofing” but defines it as “bidding or offering with the intent to cancel the bid or offer before execution.” However, many legitimate orders, including stop loss orders, are placed with the goal or hope not to have the order executed, as that would mean the value of a position is declining. Unfortunately for Mr. Coscia, the judge hearing his case did not have a problem with the clarity of the relevant statute and, in any case, believed that Mr. Coscia should have known his specific trading was prohibited. It will likely be up to an appeals court to again consider the constitutional validity of the relevant law.

Briefly:

  • Two Foreign Agribusinesses Agree to Resolve CFTC Charges for Their Alleged Failure to Report Physical Positions: The Commodity Futures Trading Commission filed and settled charges against two unrelated Singapore-based commodities trading firms for not filing with it reports of their physical positions. In one action naming Golden Agri International Pte Ltd., the CFTC claimed that, from April 2014 through October 2015, the firm failed to file with it five Form 204 reports identifying the physical positions associated with its hedge positions in soybean oil futures. Golden Agri agreed to pay a fine of US $150,000 to resolve this matter. In a separate action, the CFTC claimed that Agrocorp International Pte Ltd, a cotton dealer, failed to file with it 22 required Forms 304s at various times in 2012 and from October 7, 2014 to February 13, 2015, regarding its physical cotton positions. Agrocorp also agreed to pay a fine of US $150,000 to settle this action.

Compliance Weeds: 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 to 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.

My View: There seems to be a disproportionate percentage of non-US-based market participants caught up in CFTC enforcement actions for alleged breaches of Form 204 and 304 filing requirements. In fact, the relevant rules related to the requirements for filing such forms are a model of imprecision and are likely unclear to most domestic market participants let alone foreigners (click here to access the relevant CFTC Part 19 rules). Reference to the term “reportable” positions in connection with filing requirements as meaning positions in excess of speculative position limits in one circumstance and in excess of large trader reportable levels in another is not easy to follow. Posting of clear instructions in both English and foreign languages on the CFTC’s website would be helpful.

  • SEC Amends Rules of Practice for Administrative Proceedings to Make More Court-Like: The Securities and Exchange Commission approved amendments to the rules of practice for its administrative hearings to make them somewhat more parallel to rules of practice customary in state and federal courts. (Under SEC rules, the SEC’s Division of Enforcement can elect to bring enforcement actions in an administrative forum or federal court.) Under its new rules, parties in complex cases would be permitted to take depositions of three persons in single respondent cases and five persons in multiple-respondent cases, as well as to request an additional two depositions each under an expedited process. In addition, the SEC’s new rules explicitly permit three types of dispositive motions (i.e., motion for a ruling on the pleading; motion for summary disposition; and motion for ruling as a matter of law following completion of the case in chief) and describes the standards and procedures for such motions. The new rules also dictate when an initial decision must be issued following completion of post-hearing or dispositive motions, and provide for the exclusion of evidence that is irrelevant, immaterial, unduly repetitious or unreliable, but permits hearsay to be admitted subject to certain conditions. SEC administrative hearings have been subject to challenge as providing too much of a home-court advantage to its Division of Enforcement, although this thesis was recently rejected in a study by the SEC Inspector General. 

  • Computer Coding Error Results in Broker-Dealer Blue Sheets’ Errors Over 15 Years and US $7 Million SEC Fine: Citigroup Global Markets Inc. agreed to pay a US $7 million fine to the Securities and Exchange Commission to resolve charges that, from 1999 through 2014, it submitted 2,382 erroneous blue sheets with it and 753 erroneous blue sheets with the Financial Industry Regulatory Authority. (Blue sheets refer to trade data submitted by certain regulated entities, including broker-dealers, to the SEC and FINRA in an automated form in response to requests by the regulatory bodies in connection with their investigations, typically of equity market activity.) According to the SEC, these errors occurred as a result of a coding error in Citigroup’s electronic blue sheet computer system that was not detected until 2014. The coding error prevented the system from recognizing that data from branches that were assigned an alphanumeric code (as opposed to solely numeric branch codes) needed to be included in its blue sheet submissions, said the SEC. Moreover, the SEC claimed it was advised of Citigroup’s blue sheet issue only “over nine months after the issue was identified.” That being said, the SEC noted Citigroup’s “remedial acts … and cooperation” in accepting its offer of settlement. Separately, FINRA issued modifications to certain equity and option blue sheets’ data elements. These changes will be effective December 30, 2016.

Compliance Weeds: Just two weeks ago, Deutsche Bank Securities Inc. agreed to pay a fine of US $6 million to resolve charges brought by the Financial Industry Regulatory Authority that it filed “thousands” of deficient blue sheets with it and the Securities and Exchange Commission from 2008 through 2015. Other broker-dealers have settled enforcement actions by the SEC for fines between $2.5 and $4.25 million related to alleged blue sheet violations.  Accurate blue sheet reporting is clearly on both the SEC’s and FINRA’s radar.

  • Speakers Attack Source Code and Registration Provisions of Proposed Reg AT Before Congressional Committee: Members of the House Committee on Agriculture and all four witnesses that appeared before it last week during a public hearing on the Commodity Futures Trading Commission’s proposed Regulation Automated Trading were generally critical of the Commission’s initiative. In his opening remarks, Committee Chairman K. Michael Conaway expressly warned that the Commission’s proposal for it and the Department of Justice to have “on-demand access” to algorithmic traders’ source code “is fraught with danger.” He also suggested that the Commission’s proposal to require certain algorithmic traders who directly access exchanges to register with it as “Floor Traders” not only raises a “legal question” in light of the Congressional purpose in designing that registration category, but may also “unintentionally captur[e] thousands of end-users.” Mr. Conaway suggested that, as an alternative to its current proposed rule, the CFTC consider leveraging “already ongoing processes across the industry to impose and refine risk controls.” In his testimony, Richard Gorelick, CEO of RGM Advisors, LLC, likened the CFTC’s claimed need to access source code in order to better detect potential market disruptions to disassembling and studying the parts of an automobile in order to better predict driving conditions in the future. Mr. Gorelick also argued that “Reg AT tries to accomplish too much in a single regulation, making it unwieldy and impractical.” As a result, he and other witnesses applauded the suggested willingness of CFTC Chairman Massad to issue Regulation Automated Trading in parts, potentially addressing pre-trade and other risk controls first. (Click here for background on Regulation AT.)

My View: Reg AT should be broken apart, and solely nonprescriptive measures dealing with risk and other controls should be adopted first. A multi-industry organizations’ proposal that all algorithmic orders should be subject to risk controls capable of being administered either by the routing or sponsoring futures commission merchant or another registrant makes sense. It is not too difficult to implement and addresses a major flaw in the current proposed Regulation AT that it excludes from coverage, algorithmic trading systems of many non-registrants, except for certain algorithmic traders that trade through direct electronic access to exchanges and would be required to register with the CFTC for the first time. (Click here for a summary of comment letters received by the CFTC in response to its recently conducted roundtable.)

  • Enhancement of Broker-Dealer Disclosure Obligations Regarding Customer Order Handling Goal of SEC Proposed New Rules: The Securities and Exchange Commission proposed new rules to enhance the disclosure by broker-dealers related to the routing of customer orders. Among other things, the SEC proposed that, upon request, customers could be able to obtain specific information regarding the routing and execution of their so-called “institutional orders” (i.e., orders in exchange listed stocks with an original market value of US $200,000 or more) for the prior six months. It would also require broker-dealers to post on their website aggregate information regarding such institutional orders for each calendar quarter. The SEC proposed that, in connection with current mandatory disclosures regarding retail orders, broker-dealers provide more detailed information about payments received from or paid to execution venues; report routing information by month (not by calendar quarter); and separate reporting information for limit orders that are marketable and non-marketable. The SEC claimed that it is proposing its new rules because it believes that “market-based efforts to provide institutional order handling transparency may not be sufficient insofar as small institutional customers may lack the bargaining power or the resources to demand relevant order handling information from their broker dealers.” Comments on its order handling disclosure requirement will be accepted by the SEC through 60 days following their publication in the Federal Register.

  • Introducing Broker Settles CFTC Action for Solicitation Fraud and Lying to NFA: Atlantas Group, Inc. and Edmund Hysni agreed to settle charges brought by the Commodity Futures Trading Commission that they committed solicitation fraud and lied to the National Futures Association by paying a fine of $2.2 million and restitution to customers of $5 million. According to the CFTC, between 2006 and 2012, Atlantas, a formerly registered introducing broker, and Hysni, its former president and sole owner, grossly misrepresented the potential profits their customers would earn investing in commodity futures while representing “that their investment strategy was safe and conservative and that they had a track record of success.” The Commission said that the respondents typically invested their customers’ funds in deep out-of-the-money options while charging them US $99 or US $125/round turn. In fact, customers lost most of their money investing through respondents, alleged the CFTC. In addition, charged the CFTC, Mr. Hysni provided false information to NFA when questioned by NFA staff regarding Atlantas’s payments to an unregistered associated person. Respondents further agreed not to ever be involved in markets or products regulated by the CFTC as part of their settlement.

  • Industry Participants Generally Applaud Proposed Amendments to CFTC Position Limit Proposal But Criticize Ability to Undo Exchanges’ Determinations: In comment letters filed with the Commodity Futures Trading Commission, futures industry participants generally supported the Commission’s recent proposed changes to its November 2013 proposed position limit rules in order to permit exchanges to approve non-enumerated hedge exemptions, spread exemptions and anticipatory hedge exemptions, as well as to delay exchange-set position limits for swaps. However, industry participants were critical of (1) the potential CFTC review of any exchange-granted exemption; (2) the requirement that a designated contract market have one year of experience in administering position limits in order to grant exemptions; (3) the requirement that applications for non-enumerated or anticipatory hedges be accompanied by three years of cash market activity; and (4) the interpretation of bona fide hedging to include only price risk, as opposed to all risks that might affect cash markets, such as time risk, location risk, quality risk and credit risk. According to the Commodity Markets Council, for example, “[r]isk is inherent to commercial businesses, and the Commission should encourage commercial and end-user firms to manage risk to the fullest extent possible.” Many industry commentators also objected to the Commission’s suggestion that, where it disallowed a previously exchange-granted non-enumerated hedge, it would be “reasonable” to expect a firm to liquidate an existing futures position within one business day, and disagreed with the Commission’s proposal that non-enumerated hedge exemptions should only be approved in advance, not subsequently (subject to strict conditions), as currently is sometimes the case,

And more briefly:

  • CME Group Sanctions Two Firms for Purported Transitory EFRPs and One Individual for Non-Bona Fide Transactions: A Business Conduct Committee of the Chicago Board of Trade accepted settlements from JP Morgan Chase Bank NA and JBS USA, LLC for allegedly entering into two contingent exchange for related position transactions on March 6, 2014, where the transactions were purportedly structured to avoid “material market risk” in connection with the related positions. To resolve their CME Group disciplinary actions, JP Morgan Chase agreed to pay a fine of US $20,000 and JBS a fine of US $15,000. William Fisher was charged by CME Group with entering orders in oats futures on Globex on multiple occasions during pre-opening sessions between August 2013 and September 2014 that were not made in good faith with the intent to execute “bona fide transactions.” Mr. Fisher resolved these charges by agreeing to pay a fine of US $17,500 and have his accesses to all CME Group exchanges suspended for 20 business days.

  • OCIE Begins IA Sweep to Detect Possible Conflict of Interest Related to Recommendations of Mutual Fund Shares Classes With High Charges: The Securities and Exchange Commission’s Office of Compliance Inspections and Examinations announced that, in upcoming audits, it would specifically review whether investment advisers were making conflicted investment recommendations to their clients. OCIE said it would evaluate whether investment advisers are acting in their clients’ best interests when they make recommendations to purchase certain share classes of mutual funds (e.g., more expensive as opposed to less expensive share classes) and whether they are disclosing potential conflicts of interest, including if an adviser or any of its supervised persons accepts asset-based sales charges or service fees from the sale of mutual funds.

  • CFTC Rejects Amici Arguments in Alleged Manipulation Case: The Commodity Futures Trading Commission vehemently rejected friend of the courts’ (amici) submissions submitted in its enforcement action against Donald Wilson and DRW Investments alleging attempted manipulation. (The CFTC initially filed its lawsuit in 2013, claiming the defendants manipulated and attempted to manipulate the settlement prices of the IDEX USD Three-Month Interest Rate Swap Futures contract on numerous occasions in 2011.) Among other things, the CFTC claimed that the amici’s submissions “jettison[ed] without reference all adverse case law.” The CFTC said amici were wrong when they claimed that it must prove an intent to create an artificial price in order to prevail on its attempted manipulation charge against defendants.

Legal Weeds: In its summary of its Anti-Manipulation and Anti Fraud Final Rules (click here to access CFTC Regulations 180.1 and 180.2), the CFTC indicated that in connection with its “long-standing authority” to prohibit price manipulation “by making it unlawful … to manipulate or attempt to manipulate” (emphasis added) the price of any swap or futures contract it would be guided by its traditional four-part test for manipulation:

  • the accused had the ability to influence market prices;

  • the accused “specifically intended to create or effect a price or price trend that does not reflect legitimate forces of supply and demand;”

  • the existence of an artificial price; and

  • the accused caused the artificial price.

Certainly in a situation where the CFTC is charging only an attempt to manipulate, it is not required to prove the last two elements of its acknowledged “traditional” four-part test. But it seems disingenuous to argue that it does not have to demonstrate the first two elements. This is the CFTC’s own publication. (Click here to access the CFTC summary.)

  • Comment Period For ICE Proposed Block Trade Rule Amendment Extended by CFTC: The Commodity Futures Trading Commission extended to October 28, 2016, the date through which it will accept comments on ICE Futures U.S.’s recent proposed amendment to its block trade guidance. Under IFUS’s proposal, the principal parties to a block trade would be permitted to engage in  or anticipatory pre-hedging of the position they believe in “good faith” will result from the “consummation” of a block trade. (Click here for details of IFUS’s block trade guidance proposal.)

  • SEC Enacts Further Rules Governing Security-Based Swaps Transaction Reporting: The Securities and Exchange Commission approved amendments and guidance to rules regarding the reporting and public dissemination of security-based swap transactions. Among other things, the new rules require a national securities exchange or security-based swap execution facility to report any security-based swap executed on its platform that will be cleared, and require a registered clearing agency to report any security-based swap to which it is a direct counterparty. The SEC also issued a phased-in compliance schedule for its new amendments and guidance.

  • ESMA Proposes to Delay Mandatory Swaps Clearing for Small Counterparties: The European Securities and Markets Authority proposed to delay by two years the time by when financial counterparties with a limited volume of derivatives activity must mandatorily clear certain swaps transactions. ESMA will accept comments on its proposal through September 5, 2016.

  • EUREX Reduces Time Required From Cross Request to Mutual Executable Orders From Five to One Second: Eurex has amended its cross trade rules to reduce the minimum time a trader may enter an order following its entry of a mandatory cross request equal to the number of contracts of the order to one second from five seconds. There is also a maximum time before such orders may be executed (from 31 to 61 seconds) depending on the precise contract being traded.

  • HK Regulators Seek Forth Advice on Mandatory Clearing and Reporting Requirements for OTC Derivatives: The Hong Kong Monetary Authority and the HK Securities and Futures Commission issued further consultation conclusions regarding mandatory clearing and the expansion of reporting requirements for over-the-counter derivatives. Among other the matters, the regulators issued further clarification and guidance on specific data fields. The first phase of clearing obligations will begin under HK regulations on September 1, while the second phase of reporting obligations will come into effect on July 1, 2017.

And finally:

  • Brexit: Brexit continues to amaze and confound. My colleague Nathaniel Lalone, a Financial Services partner at Katten Muchin Rosenman UK LLP, will continue to share his insight into the evolution of the relationship between the United Kingdom and European Union in the wake of the Brexit vote. On July 13, he published an article in Bloomberg Law on the issue of the “passport,” which refers to the principle that a financial market participant authorized to conduct certain financial activities in one EU member state is generally free to conduct such activities without hindrance in other EU member states.

  • Correction: Last week’s Bridging the Weeks included an article entitled, “New FINRA Rule Governing Accounts Opened by Associated Persons at Broker-Dealer Other Than Employer Approved by SEC”. After initial publication, the Compliance Weeds accompanying the article was subsequently amended to read as follows:

Regulations of the Commodity Futures Trading Commission have equivalent requirements as FINRA regarding accounts of “affiliated persons” of futures commission merchants and introducing brokers (Click here to access CFTC Rule 155.3 and 155.4). In general, an affiliated person of such registrants needs to obtain the written authorization of his or her employer to maintain an account with a third-party FCM. Moreover, the third-party FCM must afterwards on a “regular basis” send copies of all account statements related to such an account and “all written records prepared upon receipt of orders for such account.” FCMs receiving such orders must prepare immediately upon receipt of an order for such account a written record of such order, including the account identification and order number that includes the date and time to the nearest minute when the order is received. Under relevant rules, “affiliated persons” of FCMs and IBs is broadly defined to include any general partner, director, owner of more than 10 percent, registered associated person or employee, any relative or spouse, or any relative of a spouse, who share the same home as the person directly affiliated with the relevant registrant.

©2020 Katten Muchin Rosenman LLPNational Law Review, Volume VI, Number 200
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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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