August 12, 2020

Volume X, Number 225

August 12, 2020

Subscribe to Latest Legal News and Analysis

August 11, 2020

Subscribe to Latest Legal News and Analysis

August 10, 2020

Subscribe to Latest Legal News and Analysis

Manipulation and Manipulative Device; Sue and Be Sued; Alleged Pastor Fraud; Transfer Trades - Bridging the Week: March 30 to April 3 and 6, 2015

Two household names in the food industry—Kraft Foods Group and Mondelez Global—were sued last week by the Commodity Futures Trading Commission for allegedly manipulating wheat futures contracts traded on the Chicago Board of Trade during 2011. However, the CFTC chose to charge the firms using both its traditional tools to prosecute alleged manipulation as well as its new tools to prosecute allegedly manipulative or deceptive devices. In addition, the Securities and Exchange Commission filed an administrative proceeding against the operators of a number of collateralized loan obligation funds for misleading investors, and the operators sued the SEC right back in federal court, claiming that the SEC's administrative forum is unconstitutional. As a result, the following matters are covered in this week’s Bridging the Week:

  • Manipulation Is Not Hedging Says CFTC in Federal Court Lawsuit Against Kraft Foods Group and Mondelez Global (includes My View);

  • Problematic EFRPs and Wash Trades Sanctioned by CME Group and ICE Futures U.S. (includes Compliance Weeds);

  • CME Group Updates Audit Trail Requirements for Electronic Systems Connecting to Globex;

  • SEC Charges Investment Advisers and Owner of Misleading Investors in Funds Regarding the Poor Performance of Underlying Assets; Respondents Sue SEC Right Back (includes My View);

  • Don’t Trade It Again, Shak (at Least Not During the Closing Period);

  • FINRA Sanctions Brokers for Inadequate Consolidated Reports to Customers;

  • CFTC Charges Pastor Used Peregrine Financial Group Collapse as Cover to Help Defraud Congregants; and more.

Manipulation Is Not Hedging Says CFTC in Federal Court Lawsuit Against Kraft Foods Group and Mondelez Global

The Commodity Futures Trading Commission filed a lawsuit against Kraft Foods Group, Inc. and Mondelez Global LLC claiming that trades they entered on the Chicago Board of Trade for the alleged purpose of hedging were in fact entered for the purpose of artificially lowering prices in the related cash market. This activity, claimed the CFTC, was a violation of federal law and the Commission’s rules.

According to a complaint filed by the CFTC in a federal court in Illinois, by November 29, 2011, the companies purchased 3,150 long CBOT December 2011 wheat futures contracts, which was equivalent to 15.75 million bushels or approximately US $93.5 million worth of wheat (November 29 was the first day of the delivery period for the December 2011 wheat futures contract). The companies did this, said the CFTC, with the intent to depress the price of wheat in the cash market.

Although the companies used wheat for their commercial purposes, acknowledged the CFTC complaint, they could not have used the quantity of wheat they potentially controlled at the time of the companies’ long futures purchase without incurring exorbitant costs, said the Commission. This is because they allegedly did not have sufficient storage facilities of their own.

Ordinarily, said the CFTC, the companies purchased wheat in the futures market solely as a hedge against future anticipated purchases in the cash market. Once the companies purchased cash wheat, they offset their futures hedge. The companies did not take delivery of most of the transactions at issue, however, said the Commission. Moreover, of the 1320 contracts the companies did take delivery on, they resold 1188 of their shipping certificates. 

Ultimately, the companies' actions caused the price of cash wheat to decline, alleged the CFTC. According to the Commission, as a result of their activities, the companies realized US $5.4 million in profits.

The CFTC accused the companies of engaging in manipulation and attempted manipulation through their activities, as well as engaging in a “manipulative or deceptive device or contrivance.” Under law, the former allegation requires proof of intent and an artificial price, among other elements, while the latter does not.

The CFTC also charged the companies with violating speculative position limits in connection with wheat futures positions they held on five days in December 2011. Although the companies had a hedging exemption to cover their cash needs that was effective for one year from December 1, 2010, they failed to request renewal of the exemption until December 28, 2011, noted the CFTC.

In addition, the CFTC said that the companies engaged in non-competitive trading in connection with multiples transfers of positions between different accounts that were executed as exchanges for related positions (instead of as transfer trades).

During the period covered by the CFTC’s complaint, Kraft Foods Inc. was the parent of Kraft Food Group, Inc. and its affiliate Mondelez Global LLC. In October 2012, the companies engaged in a corporate restructuring that resulted in Kraft Foods Group being one corporation owned by public shareholders and Kraft Foods Inc., its former parent, being a separate publicly traded company and renamed Mondelez International Inc.

My View: It will be interesting to follow this case to see how the charging of the respondents both under the CFTC’s traditional anti-manipulation authority (click here to access CFTC Rule 180.2) and its newly gotten anti-manipulative or deceptive device or contrivance authority (click here to access CFTC Rule 180.1) plays out. In charging respondents in a federal court with a violation of its new prohibitions, the CFTC solely argued that the companies “intended to affect or acted recklessly with regards to affecting the prices of the December 2011 wheat futures contract and engaged in over acts in furtherance of its intent”—conduct seemingly descriptive of traditional manipulation. In publishing a Q&A related to its new authority (click here to access), the CFTC argued that that its new prohibitions “enhances the Commission’s ability to prosecute manipulation.” However, the relevant provision’s prohibition against using or employing “any manipulative device,” seems limited on its face to activities “to defraud.” It is not clear whom respondents were endeavoring to defraud through their trading activities, even assuming all of the Commission’s facts, as alleged, are true. As I have stated before, CFTC Rule 180.1 is extraordinarily broad and provides little guidance as to what is precisely prohibited activity. 

Briefly:

  • Problematic EFRPs and Wash Trades Sanctioned by CME Group and ICE Futures U.S.: CME Group and ICE Futures U.S. sanctioned a number of traders for documentation issues related to exchange for related position (EFRP) transactions and for transferring positions among affiliated accounts through wash trades. In one transaction, CME Group fined EOX Holdings LLC US $40,000 for executing eight EFRP transactions between July and November 2011 and incorrectly reporting them as block trades. The firm also allegedly failed to maintain required records to support such transactions. Similarly, Newedge USA, LLC and SIPI Metals Corporation were fined US $15,000 and $7,500, respectively, by CME Group, for lacking documentation of the related cash leg of an EFRP transaction on March 17, 2014, while John Kierans was fined US $10,000 by ICE Futures U.S. for entering into “numerous” EFRP transactions involving foreign exchange from September 2011 through December 2013 without maintaining “confirmation statements to substantiate the related physical trades.” In addition, Jaypee International, Inc. and Varun Choudhary, a trader for Jaypee, were sanctioned in aggregate US $90,000 for a number of wash trades on the Commodity Exchange, Inc. and New York Mercantile Exchange Inc. between Jaypee accounts from July 2010 through March 2011 in order to liquidate concurrent long and short positions and avoid delivery.  In connection with Jaypee’s Nymex transactions, Mr. Choudhary also was suspended from trading all CME Group products for five business days. Each of the respondents voluntarily agreed to their sanctions without admitting or denying any facts or rule violations.

Compliance Weeds: In both the CFTC’s enforcement action against Kraft Foods Group and Mondelez Global filed last week, as well as the Jaypee International disciplinary action discussed in this article, companies appear to have tried to transfer positions between commonly owned accounts through impermissible non-competitive transactions. However, designated contract markets—such as the exchanges of CME Group and ICE Futures U.S.—have express provisions permitting transfers of positions between accounts with the same beneficial ownership subject to certain conditions (e.g., the trades may only be transferred at certain prices) and restrictions on when otherwise offsetting transferred positions may be liquidated outside the market. (Click here, to access CME Group’s Rule 853 regarding transfer trades, and here, to access IFUS’s Rule 4.11 regarding transfer trades.)

  • CME Group Updates Audit Trail Requirements for Electronic Systems Connecting to Globex: The CME Group revised its audit trail requirements for all entities certified to connect their front-end/order-routing systems with CME Globex. Although the new requirements are intended to be effective April 20, 2015, firms will not be required to comply with CME Group’s new requirements until April 1, 2016. Under CME Group rules, entities certified to connect a front-end/order-routing system to Globex through the exchange’s iLink gateway must create an audit trail of each message entered into the system. Clearing members guaranteeing the connection are required to maintain or cause to be maintained the electronic audit trail for at least five years and have the ability to produce data in a standard format when requested by the exchange.  In general, the new requirements require firms to capture message flow for advanced functionalities, such as parent/child relationships, and eliminate certain fields that previously were required that were determined to be redundant or yield no regulatory benefit. (Click here for current technical requirements regarding this audit trail; click here for the revised technical requirements.)

  • SEC Charges Investment Advisers and Owner of Misleading Investors in Funds Regarding the Poor Performance of Underlying Assets; Respondents Sue SEC Right Back:  The Securities and Exchange Commission commenced administrative proceedings against Lynn Tilton, and companies she owns and controls claiming that, since 2003, the respondents misled investors about the declining value of assets in collateralized loan obligation funds they managed. According to the SEC, the funds, known collectively as the “Zohar Funds,” made loans to distressed companies. Subsequently the distressed companies performed poorly and generally missed or only made partial payments on interest obligations. However, charged the SEC, Ms. Tilton directed that the loans’ valuations be reflected as unchanged since they were originated despite the fact that Tilton’s companies were obligated to provide investors in the funds accurate valuations “reflecting the financial position of each Fund.” Had the respondents correctly valued the funds at a lower amount, the respondents would have been entitled to less management and other fees, and investors would have been entitled to greater control over the funds’ activities, said the SEC. The Commission also charged that each of the Zohar funds issued non-compliant financial statements on a quarterly basis. These financial reports did not comply with generally accepted accounting principles, as required. Separately, the respondents filed a lawsuit against the SEC in federal court in New York City seeking to enjoin the agency from proceeding with the administrative proceeding, and instead require it to proceed against respondents in a federal court. Respondents claim that the administrative proceeding is unconstitutional because, among other reasons, (1) commissioners of the SEC themselves do not appoint the administrative law judges that conduct the SEC’s administrative proceedings, and (2) others besides the President of the United States may remove ALJs from office. These facts violate express requirements of the US constitution, say the respondents.

​My View: ​Previously, respondents in another SEC administrative proceeding —Wing Chau and his firm, Harding Advisory LLC— challenged in a federal court the legitimacy of the administrative forum. They lost their challenge there but were invited to raise their constitutional arguments before the  SEC. Some have argued that the US Supreme Court's 2010 decision in Free Enterprise Fund v. Public Company Accounting Oversight Board (click here to access) provides a basis for an attack on the legitimacy of SEC as well as Commodity Futures Trading Commission administrative proceedings. There, the court held that the board's members were insufficiently accountable to the president of the US to comply with the vesting of executive power in the executive branch as contemplated under the US constitution. The question is whether administrative law judges hearing SEC or CFTC enforcement actions are also too far removed from the president of the US to allow him or her to exercise effective oversight as required by the US constitution.  We shall see.

  • Don’t Trade It Again, Shak (at Least Not During the Closing Period): Daniel Shak was fined US $100,000 for violating a prior settlement with the Commodity Futures Trading Commission related to his and his company’s (SHK Management LLC) alleged manipulation of crude oil futures contracts on two days in 2008. The CFTC previously alleged that Mr. Shak violated the prior settlement when, on May 22, 2014—less than six months after signing it—he traded gold futures during the closing period   In addition to payment of a fine, Mr. Shak was also prohibited from trading futures contracts in any market during the closing period for two years. Mr. Shak had been subject to the same trading sanction in his prior settlement. 

  • FINRA Sanctions Brokers for Inadequate Consolidated Reports to Customers: The Financial Industry Regulatory Authority sanctioned three firms for not adequately supervising the issuance of consolidated reports of the financial holdings of their customers. The firms are H. Beck, Inc., LaSalle St. Securities and J.P. Turner & Company, LLC. In all circumstances, registered representatives at the relevant firms issued consolidated reports that included valuations of certain investments. FINRA permits brokerage firms to issue consolidated reports to their customers regarding their financial holdings at the specific firm and elsewhere, as a supplement to required statements, provided they are “clear, accurate and not misleading. (Click here to access FINRA’s guidance regarding acceptable consolidated reports.) In the H. Beck matter, FINRA alleged that valuation information in certain consolidated reports was incorrect; in the JP Turner matter, FINRA charged that certain disclosures were missing; while in the LaSalle St. matter, FINRA found no issues with the consolidated reports per se, but found that the firm did not follow its own procedures related to the issuance of such reports. The firms agreed to fines, in aggregate, of US $610,000, to resolve these disciplinary actions.

  • CFTC Charges Pastor Used Peregrine Financial Group Collapse as Cover to Help Defraud Congregants: The Commodity Futures Trading Commission sued Wesley Brown, Edward Rubin and Maverick International, Inc. in a federal court in Florida for committing fraud, claiming that the respondents solicited persons to participate in a pooled investment vehicle to trade futures contracts, but instead, took their money for personal use. The CFTC also claimed that Maverick—which operated as a commodity pool operator—and the two individuals—who acted as associated persons—were never properly registered with the Commission. According to the Commission, Mr. Brown used his position as an associate pastor to solicit funds from congregants in his Florida church. After respondents used the funds for their personal use, they falsely told the investors that their money had been lost in the collapse of Peregrine Financial Group when in fact it had been stolen, claimed the CFTC. The CFTC alleged that 31 persons invested US $2 million in the illegal scheme. PFG was a futures commission merchant registered with the CFTC until July 2012 when it filed bankruptcy following the revelation that Russell Wasendorf, Sr., its principal owner and chief executive officer, had committed fraud by using customer funds for his own purposes.

And even more briefly:

  • CFTC Staff Grants No Action Relief Regarding Application of Business Conduct Standards for Swaps With Certain Legacy SPVs: The Commodity Futures Trading Commission’s Division of Swap Dealer and Intermediary Oversight granted no action relief to swap dealers that enter into certain replacement swaps with certain structured finance special purpose vehicles that are triggered by a credit downgrade of a swap dealer. The relief extends solely to new swaps entered to replace old swaps that were consummated on or before October 10, 2013. In connection with such transactions, swap dealers are exempt from complying with certain of the Commission’s business conduct and documentation requirements. The replacement swap may not alter the material terms of the original swap agreement. 

  • LCH.Clearnet Recommends Standardized Stress Testing of CCPs: LCH.Clearnet has issued a paper calling for standardized stress testing of clearing houses (CCPs) globally. LCH says that implementation of standardized stress testing “will help improve transparency around CCP risk management.” According to LCH, “[it] will allow clearing members and regulators to compare different CCPs on a relative basis, to evaluate the strength and resiliency of clearing houses and to assess the extent to which a CCP’s pre-funded resources (default fund contributions and CCP skin in the game) would be consumed under a uniform set of stresses.” Among other elements stress-tested, claims LCH, should be the successful ability of a defaulted member’s cleared position to be auctioned by a clearinghouse without recourse to special assessments on members.

  • MFA Argues Against Post-Trade Disclosure of Counterparty to SEF Transactions: The Managed Futures Association has issued a paper arguing that disclosing the names of counterparties to transactions executed anonymously on a swaps execution facility “undermines Dodd-Frank Act goals.” MFA argues that the continued practice of post-trade name disclosure on dealer-to-dealer SEFs is “suppressing buy-side trading” and bifurcating swaps markets between dealer-to-dealer and dealer-to-customer SEFs, thereby impairing liquidity.

  • ISDA Proposes Common Principles Be Adopted Globally to Promote Centralized Execution of Swaps: The International Swaps and Derivatives Association has published a paper calling for the worldwide adherence to certain core principles to promote the centralized execution of swaps. These principles are that (1) the determination when swaps should be required to trade on a centralized platform should be subject to specific objective criteria; (2) swaps should be permitted to trade on different types of execution venues across jurisdictions without imposing different regulatory obligations; and (3) regulators should permit different trade execution mechanisms provided all trades are executed on a centralized venue. Adoption of these principles will help avoid market fragmentation, claims ISDA.

And finally:

  • Doctors Without Borders: This year I again will ride in the TD Five Boro NYC Bike Tour to help raise funds for Doctors Without Borders – Medecins Sans Frontieres. However, this is my first year riding this 40+-mile tour since turning 60. Doctors Without Borders consists of many selfless volunteers who place themselves in harm’s way worldwide, in some of the most unsafe places, to provide urgently needed medical care to all persons without regard to nationality, politics, religion or any other self-identifying characteristic. Please consider supporting me in my fund-raising efforts by donating to Doctors Without Borders. (Click here for details.)

For more information, see:

CFTC Charges Pastor Used Peregrine Financial Group Collapse as Cover to Help Defraud Congregants:
http://www.cftc.gov/ucm/groups/public/@lrenforcementactions/documents/legalpleading/enfbrowncomplaint032515.pdf

CFTC Staff Grants No Action Relief Regarding Application of Business Conduct Standards for Swaps With Certain Legacy SPVs:
http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/15-21.pdf

CME Group Updates Audit Trail Requirements for Electronic Systems Connecting to Globex:
http://www.cmegroup.com/rulebook/files/RA1504-5.pdf

See also, current requirements:
https://www.cmegroup.com/rulebook/files/cme-group-ra1309-5.pdf
See also, CME Group submission to CFTC explaining different between updated and existing requirements:
http://www.cmegroup.com/market-regulation/files/15-120_1.pdf

Don’t Trade It Again, Shak (at Least Not During the Closing Period):
http://www.cftc.gov/ucm/groups/public/@lrenforcementactions/documents/legalpleading/enfshakorder032715.pdf

FINRA Sanctions Brokers for Inadequate Consolidated Reports to Customers:

H. Beck:
http://images.magnetmail.net/images/clients/finra/attach/HBeck_AWC_03301...
LaSalle St. Securities:
http://disciplinaryactions.finra.org/Search/ViewDocument/37929
JP Turner:
http://images.magnetmail.net/images/clients/finra/attach/JPTurner_AWC_03...

ISDA Proposes Common Principles Be Adopted Globally to Promote Centralized Execution of Swaps:
Access at:
http://www2.isda.org/functional-areas/public-policy/united-states/page/1

LCH.Clearnet Recommends Standardized Stress Testing of CCPs:
http://www.lchclearnet.com/documents/731485/762444/Stress+Testing+Final+...

Manipulation Is Not Hedging Says CFTC in Federal Court Lawsuit Against Kraft Foods Group and Mondelez Global:
http://www.cftc.gov/ucm/groups/public/@lrenforcementactions/documents/le...

MFA Argues Against Post-Trade Disclosure of Counterparty to SEF Transactions:
https://www.managedfunds.org/wp-content/uploads/2015/04/MFA-Position-Pap...

Problematic EFRPs and Wash Trades Sanctioned by CME Group and ICE Futures U.S.:

CME Group:
EOX:
http://www.cmegroup.com/tools-information/lookups/advisories/disciplinar...
Jaypee/Choudhary:
http://www.cmegroup.com/tools-information/lookups/advisories/disciplinar...
http://www.cmegroup.com/tools-information/lookups/advisories/disciplinar...
http://www.cmegroup.com/tools-information/lookups/advisories/disciplinar...
http://www.cmegroup.com/tools-information/lookups/advisories/disciplinar...
Newedge:
http://www.cmegroup.com/tools-information/lookups/advisories/disciplinar...
Sipi:
http://www.cmegroup.com/tools-information/lookups/advisories/disciplinar...

ICE Futures U.S.:
http://www.nfa.futures.org/BasicNet/Case.aspx?entityid=0269995&case=2011...

SEC Charges Investment Advisers and Owner of Misleading Investors in Funds Regarding the Poor Performance of Underlying Assets; Respondents Countersue SEC:
http://www.sec.gov/litigation/admin/2015/ia-4053.pdf

See also, Tilton v. SEC: /ckfinder/userfiles/files/Tilton%20v%20SEC(1).pdf

©2020 Katten Muchin Rosenman LLPNational Law Review, Volume V, Number 96

TRENDING LEGAL ANALYSIS


About this Author

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

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

Previously, Gary was a senior...

212-940-6558