Bridging The Week - January 2020 #4

Katten Muchin Rosenman LLP

The Commodity Futures Trading Commission proposed to revise its position limits regime by increasing to 25 (from nine) the number of commodity derivatives contracts subject to federal limits; by augmenting the number of enumerated bona fide hedging exemptions; and by expediting the process for persons legitimately requiring non-enumerated hedge exemptions to gain approvals. Two commissioners objected to the proposal. Separately, a futures commission merchant was fined US $650,000 by a panel of the business conduct committee of the Commodity Exchange, Inc. for purportedly mishandling the reporting of positions in an omnibus account of a brokerage firm client and responding inaccurately to the exchange’s investigatory inquiries – although it solely passed along audit trail information provided to it by the customer. As a result, the following matters are covered in this week’s edition of Bridging the Week:

  • CFTC Positions Itself In a Bona Fide Way to End Nearly Decade-Old Speculative Limits Reset Saga (includes My View);
  • Omnibus Account Handling Purported Missteps Lead to Carrying FCM Paying US $650,000 COMEX Fine (includes Compliance Weeds1 and Compliance Weeds2);
  • SEC OCIE Shares Effective Cybersecurity Techniques Observed During Registrants’ Examinations (includes Compliance Weeds); and more.

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  • CFTC Positions Itself In a Bona Fide Way to End Nearly Decade-Old Speculative Limits Reset Saga: Over the vehement dissents of two commissioners, the Commodity Futures Trading Commission proposed an overhaul of its speculative position limits regime at a public meeting held on January 30. Most significantly, the Commission proposed to (1) increase by 16 to 25 the number of physically deliverable commodity derivatives contracts on which it will impose position limits; (2) increase the number of enumerated hedging strategies on which a market participant could rely to avoid the constraint of the limits for bona fide commercial purposes; and (3) introduce an expedited process relying on designated contract markets in the first instance to utilize non-enumerated hedging strategies to also avoid position limits for bona fide commercial reasons.

Currently, only nine referenced futures contracts are subject to federal position limits – in the spot and non-spot months and all months combined. These legacy referenced futures contracts are all agriculture based. Generally, persons holding relevant futures or options on relevant contracts cannot exceed on a futures equivalent basis speculative position limits established by the CFTC except for bona-fide hedging purposes.

According to the Commission, the proposal aims to (1) recognize differences in commodities and commodity derivative contracts; (2) address derivative contracts “that are critical to price discovery and distribution of the underlying commodity” to help avoid excessive speculation in the particular contracts having “a particularly acute impact on interstate commerce” for that commodity; and (3) rely on DCMs and their expertise and processes to “reduce duplication and inefficiency.”

As proposed, only the nine legacy referenced futures contracts would be subject to federal spot, non-spot and all months’ limits and the spot limits would be substantially increased from current levels for most contracts – in most cases by at least double. The new, additional referenced futures contracts would be subject to federal spot month limits only; however, the DCMs listing the relevant futures contracts would establish limits or accountability levels outside the spot month. These new referenced futures contracts include seven new agricultural contracts, four energy contracts and five metals contracts.

All spot month limits are proposed to be set at less than twenty-five percent of deliverable supply as estimated by data provided by DCMs. Relevant futures equivalent positions would be calculated by combining a persons’ futures, options on futures and economically equivalent swaps positions. These swaps are those with identical material contractual terms as the corresponding futures contracts.

The types of enumerated hedges that could be engaged in by commercial entities with no CFTC prior approval would be expanded beyond currently authorized hedges to include anticipatory merchandising, hedges by agents, hedges of anticipated royalties, hedges of services, and offsets of commodity trade options. Hedging exemptions would still have to be applied for and granted by DCMs. A qualified person could also apply to exchanges for non-specified hedges; if granted, a DCM would notify both the CFTC and the applicant, and the CFTC – through its commissioners only (not staff) – would have ten days to disallow such non-enumerated hedging exemption. A quicker process would also potentially be available for persons demonstrating a more immediate need. This process echoes the CFTC’s process for self-certification by DCMs of amendments to existing rules.

In evaluating their positions against federal position limits, market participants could measure their risk on a gross or net basis. However, they must do so consistently and not to evade federal limits. As proposed, market participants would have the ability to hold bona fide hedge positions in excess of federal positions limits during the last five days of the spot period (or during the spot month if less than five days), and hedgers would no longer be required to file reports of their cash positions on a monthly basis with the CFTC on Forms 204 and 304.

As a predicate for implementing position limits on the referenced contracts, the Commission proposes to conclude that each recommended position limit is necessary and “would be an efficient mechanism to advance the congressional goal of preventing undue burdens on interstate commerce in the given underlying commodity caused by excessive speculation.” The Commission will take the view based on its analysis that only the position limits on the 25 referenced contracts are necessary and not on all physical commodity deliverable contracts.

In objecting to the Commission’s proposal, Commissioner Dan Berkovitz argued that the delegation of the consideration of non-enumerated hedge exemptions to DCMs in the first instance would demote the agency from “head coach over the hedge exemption process to Monday-morning quarterback for exchange determinations.” He also disagreed that the Commission must make a finding that position limits on particular commodities are “necessary” prior to imposing such position limits and expressed concern that there would be no phase-in to higher spot month limits “by a factor of two or more” (compared to existing federal or DCM limits) on the 25-referenced contracts. Commissioner Rostin Behnam also objected to the agency’s application of a necessity standard and deference to DCMs. Contrariwise, Heath Tarbert, CFTC Chairman, lauded the Commission’s proposals, arguing that “If adopted, our proposal will help ensure that futures markets in agriculture, energy and metals commodities work for American households and business.” Commissioners Brian Quintenz and Dawn Stump also wrote concurring opinions supporting the agency’s proposal.

If adopted, market participants would have to comply with the new proposed positions limit regime by 365 days after publication of the final rule in the Federal Register. The Commission will accept comments on its new proposal only through April 29, 2020 – 90 days after the Commission’s release of its proposed new rules.

My View: The CFTC commissioners’ debate over the requirement of a necessity determination derives from a somewhat ambiguously worded statutory provision (click here to access the Commodity Exchange Act §6a(a), 7 U.S.C. §6a(a)) and unclear language in a court decision that neutralized the Commission’s first effort to revise its position limits regime in 2011, following the amendment of the relevant statutory provision in the Dodd Frank Wall Street Reform and Consumer Protection Act in 2010 (click here to access the relevant court decision). Reasonable persons could fairly disagree on the law’s precise meaning.

However, Commissioner Stump’s statutory analysis – using both writing and a diagram – of the legal basis for the view that the Commission must find it “necessary” to impose specific position limits before actually imposing them is compelling and worth reading. Moreover, her plain sense reaction to the proposal following multiple prior efforts since 2011 to get position limits right is persuasive: “[I]t is not surprising that each of us will have a different view of the perfect position limits framework. Perfection simply cannot be the standard by which the proposal is judged.”

Smart words.

After almost ten years of trying to get it right and one lawsuit delaying the process, it’s time to move on. The current CFTC proposed position limits regime is not perfect, but it is thoughtful, meets Congressional expectations, and with whatever tweaks are necessary to make it better, should be adopted.

  • Omnibus Account Handling Purported Missteps Lead to Carrying FCM Paying US $650,000 COMEX Fine: ADM Investor Services, Inc. agreed to pay a fine of US $650,000 to the Commodity Exchange, Inc related to its alleged mishandling of the account of a brokerage firm client from March 2012 through May 2018. According to a panel of the exchange’s business conduct committee, beginning in March 2012, ADMIS learned that the customer "automatically" offset positions in its omnibus account on a first-in first-out basis. The BCC panel claimed this information was never escalated to the appropriate person at ADMIS, however.

Also, beginning February 2017 through at least May 2018, said the panel, at least one ADMIS employee became aware that, in connection with copper futures, the customer was misreporting position data to the exchange. Following this, ADMIS allegedly provided the client with incorrect guidance, and purportedly assisted the client in misreporting. As a result, claimed the BCC panel, “ADMIS failed to require the client to provide” accurate reporting information as required under exchange rule (click here to access Rule 561(C)).

Finally, alleged the panel, after COMEX began a series of investigations regarding ADMIS’s client in September 2017, the client’s responses to COMEX’s requests were “untimely and inaccurate” and on multiple occasions, ADMIS passed along audit trail data provided by its client that was not correct. The panel also charged ADMIS with failing to “properly” supervise employees about escalation procedures after one of its employees recognized the client violated exchange rules.

Separately, three market participants consented to sanctions by CME Group exchanges for purportedly not reporting block trades to the relevant exchange timely and accurately. The firms were Coquest Inc. that agreed to a US $150,000 fine to the New York Mercantile Exchange and disgorgement of US $74,365; Creditex Securities Corporation which consented with NYMEX to a US$ 60,000 fine; and GFI Brokers Limited which agreed with COMEX and NYMEX to pay a US $70,000 fine. Coquest was also charged with trading opposite a customer through a company-controlled account at prices advantageous to Coquest after receiving the customer’s block trades orders but prior to consummating the relevant transactions. The relevant exchanges also charged Creditex – part of the ICE group of companies – and GFI with failing to adequately advise and train their employees regarding CME Group’s block trades rules.

Additionally, Liang Chen and Tanius Technology LLC were each charged with unrelated breakdowns in their automated trading systems that caused disruptions to relevant markets. Mr. Chen agreed to pay a US $30,000 fine and be banned for 30 days from accessing any CME Group exchange and Tanius consented to pay a US $35,000 fine.

Compliance Weeds1: FCMs carrying omnibus accounts either for other FCMs or foreign brokers have special obligations in connection with such accounts. At the highest level, FCMs' risk management programs must provide for specific due diligence and oversight for the carrying and surveillance of all omnibus accounts.

Most importantly, omnibus accounts – accounts disclosed in the name of a brokerage entity but ordinarily containing positions of non-disclosed ultimate customers of the brokerage firm – should not be set-up on a first in-first out basis unless there is solely one underlying customer and should be carried and margined on a gross basis assessing at least exchange-minimum maintenance margin levels. (Click here to access CFTC Rule 1.58(a) and here for Joint Audit Committee Regulatory Alert 18-02 (June 6, 2018).) However, individual positions in an omnibus account may be margined as spread or hedge positions provided the carrying FCM receives and retains a written representation from the omnibus broker that each such position is entitled to be so margined (see CFTC Rule 1.58(b)). Omnibus accounts margin calls should be met within three business days where Day 1 is the day a margin call arises because of new positions and/or market moves, Day 2 is when a margin call is issued and Day 3 is the first day a margin call is outstanding; on Day 3 an FCM must book an undermargined charge in connection with a delinquent omnibus account margin call (see JAC Alert 18-02).

Omnibus accounts should be clearly identified on the records of an FCM, demarcated as house or customer, and set up to ensure that domestic futures and options, non-US futures and options and swaps are maintained in separate customer protection environments. (Click here to access a relevant Commodity Futures Trading Commission Division of Swap Dealer and Intermediary Oversight guidance (September 28, 2012). See also JAC Alert 18-02.)

FCMs must ensure they receive reports of daily close-outs of positions in an omnibus account on a timely basis so they may remit required position information timely to the CFTC, other FCMs or clearing houses, as necessary. (Click here to access CFTC Advisory 13-16 (May 23, 2013).)

Special notification requirements pertain to omnibus accounts meeting payment obligations in other than readily available funds. (Click here for NFA Compliance Rule 2-33.) Also, immediate notification to the CFTC and the FCM's self-regulatory organization is required when a trading account carried for another FCM must be liquidated or transferred due to the account's failure to meet a margin call. Click here to access CFTC Rule 1.12(f)(2).

Other obligations for omnibus accounts also apply. FCMs should be aware of all their obligations under CFTC, NFA and exchanges' requirements (click here, e.g., to access CME Group RAS17813-5 (see section entitled Omnibus Account Reporting)).

Compliance Weeds2: With increasing regularity, clearing members are being held responsible by regulators for allowing clients to continue to allegedly violate applicable rules, not taking appropriate action when on notice of such violations, and/or passing along to regulators inaccurate information received from clients.

In 2016, the CFTC named Advantage Futures LLC, another FCM, in an enforcement action related to the firm’s handling of the trading account of one customer in response to three exchanges’ warnings, among other matters. The firm and the two officers that were named as defendants agreed to pay a fine of US $1.5 million to resolve the CFTC action. According to the CFTC, between June 2012 and April 2013, three exchanges alerted Advantage to concerns they had regarding the trading of one unspecified customer’s account which they considered might constitute disorderly trading, spoofing and manipulative behavior, in violation of the exchanges’ relevant rules. The CFTC claimed that Advantage initially failed “to adequately respond to the [exchanges’] inquiries and did not conduct a meaningful inquiry into the suspicious trading.” Only after the three exchanges threatened to hold Advantage responsible for its customer’s conduct did Advantage cut off the trader’s access to the three exchanges. However, Advantage failed to augment its oversight of the trader’s remaining trading or control his access to other exchanges “despite knowing that he employed the same strategy across all markets.” (Click here for background in the CFTC enforcement action against Advantage Futures in the article “FCM, CEO and CRO Sued by CFTC for Failure to Supervise and Risk-Related Offenses,” in the September 25, 2016 edition of Bridging the Week.)

In 2017, Merrill Lynch, Pierce, Fenner & Smith Incorporated agreed to pay a fine of US $2.5 million to resolve charges brought by the CFTC that it failed to diligently supervise responses to a CME Group Market Regulation investigation related to block trades executed by its affiliate, Bank of America, N.A. on the CME and the Chicago Board of Trade. The CFTC said that the responses provided by BANA were not accurate. However, there was no indication that Merrill Lynch was aware or had reason to believe that its affiliate’s responses were inaccurate. (Click here for further details in the article “FCM Agrees to Pay US $2.5 Million CFTC Fine for Relying on Affiliate’s Purportedly Misleading Analysis of Block Trades for a CME Group Investigation,” in the September 24, 2017 edition of Bridging the Week.)

COMEX’s current disciplinary action against ADMIS is the latest example of the trend.

In response, FCMs should have policies and procedures that require employees to promptly escalate knowledge or even concerns about clients’ possible non-compliance with rules, and require supervisors promptly to evaluate and act-upon (or formally close-out, if warranted) such information. Moreover, firms should not blindly pass along to regulators information received from clients they suspect may be inaccurate; at a minimum, FCMs should challenge their clients regarding such information, and consider maintaining evidence of such challenge and outcome.

  • SEC OCIE Shares Effective Cybersecurity Techniques Observed During Registrants’ Examinations: The Securities and Exchange Commission’s Office of Compliance Inspections and Examinations said that effective cybersecurity programs begin with the “right tone at the top” in a summary of observations made at SEC registrants published last week.

OCIE said that it saw at registrants with effective cybersecurity programs a risk assessment process that helps identify, manage and mitigate potential cyber risks; comprehensive written policies and procedures addressing cybersecurity coupled with ongoing testing and monitoring to confirm the effectiveness of the policies; prompt responses to testing and monitoring results as well as amending policies to address any weaknesses; and robust internal communications.

Good company policies and procedures that OCIE has seen address access rights and controls; use of measures to minimize potential data loss such as vulnerability scanning, perimeter security, and implementation of capabilities that can assist identifying threats; patch management; inventory of hardware and software; encryption and network segmentation; insider threat monitoring; and securing legacy systems and equipment. Registrants also maintain policies and procedures regarding mobile devices, have plans that are tested and used addressing incident response; ensure vendors meet cybersecurity standards; and engage in effective staff training.

In issuing its observations, OCIE made no formal recommendations but indicated that cybersecurity is a key priority for it and has been a prime element in its examination program for eight years.

Compliance Weeds: By the end of the first quarter 2020, two states’ recently adopted requirements around cybersecurity could impact out-of-state and otherwise regulated businesses.

New York’s Stop Hacks and Improve Electronic Data Security (SHIELD) law that was enacted during July 2019 broadened the scope of the type of personal information subject to New York’s breach notification laws, and extended breach notification obligations to all businesses – whether or not located in NY – that collect private information of NY residents. Moreover, a breach notification may be required when private information is improperly accessed even if not acquired; notification may be required to the NY Attorney General and other state agencies even when reporting obligations may already exist under certain federal laws. Out of state businesses collecting private information regarding NY residents may also be required to implement a data security program reasonably designed to protect the security and confidentiality of private information. The SHIELD Act’s notification requirements went into effect on October 23, 2019 while its data security requirements commence March 21, 2020. (Click here for additional information in a Katten Advisory dated August 1, 2019.)

Similarly, the California Consumer Privacy Act also went into effect on January 1, 2020. The law established requirements for certain for-profit businesses doing business in California – even from out of state – that collect or sell consumer personal information or discloses consumer data for business purposes. The definition of personal information is also quite broad under the statute. A private right of action exists under the relevant law and it appears class actions are possible; additionally, the state’s attorney general can also bring enforcement actions. (Click here and here to access two Katten advisories regarding the CCPA published last year.)

More Briefly:

  • Allegedly Misrepresenting Risk in Mutual Fund Results in US $10 Million Sanction by SEC and CFTC on Fund Manager and CEO: Both the Commodity Futures Trading Commission and the Securities and Exchange Commission brought and settled enforcement actions against Catalyst Capital Advisors LLC and Jerry Szilagyi, Catalyst’s chief executive officer and majority owner, for the materially misleading statements of Catalyst and one of its portfolio managers regarding its risk controls. Catalyst is registered with the CFTC as a commodity pool operator and with the SEC as an investment adviser. Mr. Szilagyi also has various personal licenses with the SEC.

According to both agencies, Catalyst operates a number of funds including the Catalyst Hedged Futures Strategy Fund. The Fund was Catalyst’s largest, having over US $4 billion in assets under management in November 2016; the Fund invested in S&P futures options, mostly taking short positions. Although Catalyst and its agents represented that the Fund maintained strict risk controls that were designed to limit losses, the agencies’ alleged that the represented risk controls were often not in place. As a result, charged the agencies, when the market rallied 4.4% from February 9 through March 1, 2017, the Fund’s value declined over 19%.

The agencies charged that Catalyst’s misrepresentations operated as a fraud and that Catalyst failed to have an adequate supervisory system to detect and try to prevent misleading statements. The CFTC charged that Mr. Szilagyi was liable for Catalyst’s supervisory failures as a control person, while the SEC charged him with failure to supervise and otherwise being responsible for Catalyst’s principal offenses.

To resolve the agencies administrative proceeding, Catalyst agreed to pay US $1.3 million as a fine and almost US $9 million in disgorgement (including interest), while Mr. Szilagyi agreed to pay a fine of US $300,000. Payments made to one agency by the defendants will offset payment obligations to the other agency. In settling with defendants, the SEC acknowledged Catalyst’s voluntary remedial efforts, including enhancements to its risk management and supervisory functions, after its investigation of the investment manager began.

Separately, Edward Walczak, the Funds’s portfolio manager, was charged with making material misrepresentations by both agencies in separate complaints filed in a US federal court in Wisconsin. Both agencies seek an injunction, disgorgement and fines against the defendant.

  • CFTC Proposes to Ease Execution of Package Transactions and Block Trades and Resolution of Error Trades on SEFs: The Commodity Futures Trading Commission proposed amendments to certain of its rules to accommodate the execution of package transactions and block trades and the resolution of error trades on swap execution facilities in a more flexible manner than prescribed by existing rules. Among other things, the CFTC proposed to authorize (1) the components of certain categories of package transactions to be executed on SEFs through flexible means other than the mandatory methods for transactions required to be executed on a SEF; (2) block trades to be executed through non-order book methods of executions; and (3) SEFs to apply flexible approaches to error trades resolution that do not mandate prescribed methods of execution for required transactions. These matters are already subject to some relief by the CFTC through no action letters.
  • Flash Crash Spoofer Sanctioned to One-Year Home Confinement: Navinder Sarao was sentenced to one-year home confinement in connection with his guilty plea to criminal charges previously brought against him by the Department of Justice for allegedly engaging in manipulative conduct through spoofing-type activity involving E-mini S&P futures contracts traded on the Chicago Mercantile Exchange between April 2010 and April 2015, including illicit trading that purportedly contributed to the May 6, 2010, “Flash Crash.” (Click here for background in the article “Alleged Flash Crash Spoofer Pleads Guilty to Criminal Charges and Agrees to Resolve CFTC Civil Complaint by Paying Over $38.6 Million in Penalties” in the November 13, 2016 edition of Bridging the Week.)

Both defendant’s counsel’s and the DOJ’s recommendation that Mr. Sarao solely be sentenced to time previously served was rejected by the presiding federal court judge, the Hon. Virginia Kendall. Defendant’s counsel had recommended such sentence based on his observations regarding Mr. Sarao’s autism. According to papers he submitted, Mr. Sarao knew that spoofing was wrong, but he was obsessed by spotting spoofing occurring constantly at the CME. When he believed the exchange failed to take action, despite him complaining “over and over …for months,” Mr. Sarao “began to do what he complained about.” Mr. Sarao’s counsel said that the defendant essentially saw trading on CME as a video game and has fully cooperated with the DOJ to explain markets and how his former “opponents” are allegedly cheating on them.

  • FINRA Seeks Comments on Proposal to Extend Authorities of Capital Acquisition Brokers: The Financial Industry Regulatory Authority requested comments on proposed amendments to its rules restricting activities of entities registered as capital acquisition brokers. These entities are solely authorized to engage as placement agents for sales of unregistered securities to institutional investors and advising equity funds and companies on capital raising and corporate restructuring. Among other things, the proposed amendments would authorize CABs also to be registered as investment advisers and provide advisory services solely to institutional clients; expand the scope of eligible institutional investors CABs may deal with to knowledgeable employees; allow CABs to be compensated in the form of securities issued by a privately held CAB client; and require CABs to adopt policies and procedures to preclude insider trading where such risks may exist. FINRA will accept comments through March 30, 2020.
  • Fintech High on IOSCO’s 2020 Work Program Priorities: The International Organization of Securities Commissions identified two Fintech topics – cryptoassets and artificial intelligence and machine learning – among the five priories in its 2020 work program. In 2020, IOSCO intends to issue a final report on issues, risks and regulatory considerations regarding trading platforms for cryptoassets; continue to develop a “support framework” to assist its member address domestic and cross-border issues related to initial coin offerings; and report on regulatory issues concerning global stablecoins. IOSCO also intends to consult and issue a final report of the use of artificial intelligence and machine learning by intermediaries and asset managers. IOSCO additionally plans to address market fragmentation, passive investing and index providers and retail distribution digitization in 2020. IOSCO is the principal international policy forum for securities and derivatives regulators worldwide.

For further information:

Allegedly Misrepresenting Risk in Mutual Fund Results in US $10 Million Sanction by SEC and CFTC on Fund Manager and CEO:

CFTC Positions Itself In a Bona Fide Way to End Nearly Decade-Old Speculative Limits Reset Saga:
Voting Draft: Position Limits for Derivatives

  • Supporting Comments:

Chairman, Heath Tarbert:
Commissioner Brian Quintenz:
Commissioner Dawn Stump:

  • Dissenting Comments:

Commissioner Rostin Behnam:
Commissioner Dan Berkovitz:

CFTC Proposes to Ease Execution of Package Transactions and Block Trades and Resolution of Error Trades on SEFs:
Voting Draft: Amendments to Certain Swap Execution Facility Requirements and Real-Time Reporting

Fintech High on IOSCO’s 2020 Work Program Priorities:

FINRA Seeks Comments on Proposal to Extend Authorities of Capital Acquisition Brokers:

Flash Crash Spoofer Sanctioned to One-Year Home Confinement:

Omnibus Account Handling Purported Missteps Lead to Carrying FCM Paying US $650,000 COMEX Fine:

SEC OCIE Shares Effective Cybersecurity Techniques Observed During Registrants’ Examinations:

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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