Bridging the Week - September 2016 #3

Katten Muchin Rosenman LLP

FCM, CEO and CRO Sued by CFTC for Failure to Supervise and Risk-Related Offenses

Advantage Futures LLC, Joseph Guinan, its majority owner and chief executive officer, and William Steele, who until May 2016 was Advantage’s chief risk officer, settled charges brought by the Commodity Futures Trading Commission related to the firm’s handling of the trading account of one customer in response to three exchanges’ warnings and for the firm’s alleged failure to follow its own risk management policies. The defendants agreed to pay a fine of US $1.5 million to resolve the CFTC’s enforcement 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, initially, Advantage failed “to adequately respond to the Exchange inquiries and did not conduct a meaningful inquiry into the suspicious trading.” Among other things, said the CFTC, no person at Advantage talked to the relevant trader regarding the identified activity. Only after the three exchanges threatened to hold Advantage responsible for its customer's conduct, did Advantage cut off the trader’s access to three exchanges, observed the CFTC. However, noted the CFTC, 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.”

In addition, charged the CFTC, Advantage did not follow its own risk management policies. Among other specific failures, said the CFTC, Advantage did not follow its risk management program (RMP) adopted pursuant to CFTC requirement (click here to access CFTC Rule 1.11) regarding the role of its credit committee; the use of risk ratings; the account opening process; and the implementation and review of risk tolerance levels.

Also, claimed the CFTC, Advantage did not establish risk-based limits for each customer, as required based on position size, order, margin requirement or similar factors. (Click here to access CFTC Rule 1.73(a)(1).) Instead, observed the CFTC, Advantage relied on position limits for its risk-based pre-control limits, which it said was “an inadequate risk-based control method” for day trader customers.

The CFTC charged that when Advantage submitted its RMP manual, credit and risk policies and procedures manual and chief compliance officer annual report to it on “multiple occasions” between November 2013 and May 2015, Mr Guinan and Mr. Steele “knew that the documents did not accurately represent Advantage’s actual practices” and therefore contained false or misleading statements in violation of applicable law. (Click here to access Commodity Exchange Act Section 6(c)(2), 7 USC §9(2).)

All three respondents were charged by the CFTC with failure to supervise, Advantage and Mr. Steele were charge with failure to comply with the firm’s risk management program requirements, while Advantage alone was charged with failure to establish risk-based limits and submission of false documents to the CFTC.

In addition to payment of a fine, Advantage agreed to implement strengthened procedures related to its risk management program and risk department in order to resolve the CFTC’s charges.

Compliance Weeds: CFTC staff recently issued guidance regarding its views on effective risk management programs by futures commission merchants. As part of their regulatory obligation, FCMs must address market, credit, liquidity, foreign currency, legal, operational, settlement, segregation, technological, capital risks and any other applicable risks in their RMPs. Staff's advice went beyond restating the mere four corners of the relevant regulation, and provided insight into specific elements of FCM RMPs and periodic risk exposure reports they had reviewed. These provisions included, among others, descriptions of the technical systems used by FCMs to conduct their business and how the systems interacted for risk management purposes and the procedures for monitoring relevant risks. It may be useful in light of the CFTC’s enforcement action against Advantage for FCMs to consider their own RMPs against the contents of other RMPs identified in the staff guidance. (Click here for a discussion of the staff’s guidance in the article, “CFTC Staff Issues Guidance on Elements of an Effective FCM Risk Management Program” in the March 13, 2016 edition of Bridging the Week.) Moreover, all FCMs should periodically review all adopted procedures, including those pertaining to their RMP, to assess if they are being followed and, if not, to amend or implement them as appropriate.

In addition to the CFTC’s authority to bring actions against FCMs for failure to supervise, CME Group clearing members are expected to “suspend or terminate” a non-member’s customer’s Globex access if the exchange “determines that the actions of the non-member customer threaten the integrity or liquidity of any contract or violate any Exchange rule or [applicable law]." Moreover, “[i]f a clearing member has actual or constructive notice of a violation of Exchange rules in connection with the use of Globex by a non-member for which it has authorized a direct connection and the clearing member fails to take appropriate action, the exchange member may be found to have committee an act detrimental to the interest or welfare of the Exchange.” (Click here to access CME Group Rule 574.) ICE Futures U.S. has equivalent requirements. (Click here to access IFUS Rules 27.04 (c)(iii) and (d).) Clearing members should not ignore an exchange’s or other third party’s identification of the possible problematic trading of any customer and, at a minimum, should evaluate such trading for compliance with its own requirements.


  • Futures Block Trades' Prices at Midpoint of Related Swaps Bid-Ask Were Not Fair and Reasonable Says CFTC in Enforcement Action: JSC VTB Bank (VTB), a Russia-based bank, and VTB Capital PLC (VTB Capital), a UK-based bank that is ultimately 94% owned by VTB, were sued by the CFTC for engaging in block trades with each other contrary to CME Group rules, in that the prices of the block trades were not “fair and reasonable.” According to the CFTC, between December 2010 and June 2013, the two companies engaged in more than 100 block trades involving CME Group’s Russian Ruble/US Dollar futures contracts. The CFTC alleged that the companies engaged in these transactions to transfer certain Russian Ruble/US dollar risk from VTB to VTB Capital. However, in doing so, said the CFTC, the defendants chose a price for their block trades that “typically” reflected the midpoint between the prevailing bid-ask spread of the over-the-counter RUB/USD swap. The CFTC said that, because the defendants did not seek other block trade prices from other counterparties, the prices chosen by the defendants for their block trades were not fair and reasonable prices, as required by CME Group rules. Thus the block trades were unlawful noncompetitive trades under the applicable CFTC rule. (Click here to access CFTC Rule 1.38(a).) To resolve the CFTC’s complaint, defendants agreed to pay a fine of US $5 million and to institute or enhance procedures to avoid noncompetitive transactions.

Legal Weeds: Block trades are a type of noncompetitive transaction permissible under rules of the Commodity Futures Trading Commission if they are executed strictly in accordance with the applicable exchange’s rules. If they are not so executed, the transaction may be a violation of not only the applicable exchange’s rules, but of applicable law and CFTC rules. (Click here for background regarding block trades in the article, “Block Trade Requirements Must Be Followed Strictly; No Chips Off the Old Block Trade Rules Permitted” in the January 10, 2016 edition of Bridging the Week.) According to CME Group, the prices of block trades must be fair and reasonable considering (1) the size of the transaction; (2) the prices and sizes of other transactions in the same contract at the equivalent time; (3) the prices and sizes of transactions in other relevant markets; and (4) the circumstances of the markets or the parties to the block trade. Here, according to the CFTC complaint, the price of the allegedly problematic block trades was the midpoint of the bid-ask spread of the related swap instrument. Moreover, VTB claimed that, at the time of execution of the allegedly problematic block trades, the market in the RUB/USD futures contract was illiquid. Given these circumstances, it is hard to understand how the CFTC concluded that the prices of the relevant futures contracts were not fair and reasonable. That being said, CME Group prohibits block trades between accounts with common beneficial ownership unless each party’s decision to trade was made independently. Given that VTB and VTB Capital appear to be under common beneficial ownership and acted in concert to effectuate a risk transfer from VTB to VTB Capital, it seems odd that the CFTC did not allege that this aspect of the relevant block trades was problematic, as opposed to the quality of the prices. Indeed, the CFTC noted in its Order that “[t]he block trades by design, did not create any market risk to the combined VTB entities because, ultimately, any financial gains and losses from these trades were consolidated on VTB’s books.” Ordinarily exchanges give wide latitude to the prices decided between parties to a block trade because such prices are reported to the public independently of trade prices in the ordinary market, are not included in the daily trading range and will not set off any conditional orders. (Click here to access CME Group’s Market Regulation Advisory Notice regarding block trades; click here to access similar guidance by ICE Futures U.S.) Regrettably, it is not clear what message the CFTC is endeavoring to provide traders and execution facilities regarding acceptable prices for block trades going forward.

  • CME Group Overhauls EFRP Rule and Guidance; Clarifies Roles of Executing and Clearing Firms and Provides New Relief: The CME Group self-certified amendments to its rules and guidance related to exchange for related position transactions that, among other things, make clear that firms executing or clearing EFRPs must exercise “due diligence” to identify situations where a customer’s EFRP transactions may be “non-bona fide,” and permit EFRPs to contain multiple exchange components that may not have the same market bias. CME amendments also permit any third party, not just members, to facilitate as principal the related position component of an EFRP; make clear that the related position associated with an exchange of an exchange-traded option for an option transaction must be an over-the-counter option and that all account statements confirming EFRPs must “uniquely” identify such transactions (e.g., not just identify them generically as Ex-pit); and authorize commodity trading advisors, account controllers or other persons acting on behalf of another person not to have to pass along to an ultimate customer the initiating and offsetting foreign currency leg of an immediately offsetting foreign currency EFRP. In connection with EFRPs involving equity index contracts, CME Group eliminated the requirement that the related position component have a historical correlation to the index of 90 percent or greater and replaced it with a requirement that related position stock baskets simply be “highly correlated” to the index, without referencing a specific percentage. Absent objection by the Commodity Futures Trading Commission, CME Group’s new rule and guidance will be effective October 4.

Compliance Weeds: For EFRPs, one party must sell the exchange contract and buy approximately the same quantity of the related position (or the market exposure associated with the related position), while the other party must buy the exchange contract and sell the same approximate quantity of the related position or associated market exposure. The related position must be the cash commodity associated with the exchange contract or a by-product, a related product or an over-the-counter derivative instrument of such commodity that is reasonably correlated to the exchange contract. EFRPs must result in a real transfer of a cash commodity between the parties or a legal binding agreement between the parties governing the related position consistent with prevailing market conventions. Transitory EFRPs – where one EFRP is contingent on the execution of another EFRP or related position transaction and where the overall transaction results in the liquidation of the related position without either party incurring market risk – are strictly prohibited

  • Audit Firm Agrees to Two Fines Totaling $9.3 Million for Two Partners’ Cozy Relationship With Audit Client Contacts: Ernst & Young agreed to pay fines totaling US $9.34 million to resolve charges that two of its partners maintained personal relationships with their contacts at their audit clients that were too close to maintain auditor impartiality and objectivity. In one action naming E&Y, Robert Brehl, Pamela Hartford and Michael T. Kamienski, the SEC charged that, between March 2012 and June 2014, Ms. Hartford, who at first was the engagement partner and then the coordinating partner on E&Y’s engagement with an unspecified public company that was an audit client, maintained a romantic relationship with Mr. Brehl, who at the time was the chief accounting officer at the client. However, during this time, said the SEC, E&Y represented that it was independent in connection with audit reports filed with the agency. However, “[a] reasonable investor with knowledge of all relevant facts and circumstances concerning Hartford’s personal relationship with Brehl would conclude that Hartford was not capable of exercising objective and impartial judgment with respect to the audits of the Issuer.” According to the SEC, Mr. Kamienski was the coordinating partner on E&Y’s engagement prior to Ms. Fulton’s appointment, and had a senior role with E&Y afterwards. The SEC claimed that from early June 2013 through June 2014, he “was aware of facts” that suggested the romantic relationship but did not perform a “reasonable inquiry” to follow up or forward his knowledge to a group within E&Y charged with ensuring the audit firm’s independence from its clients. To resolve this matter, E&Y agreed to pay a fine of US $4.366 million while Ms. Hartford and Mr. Brehl consented to pay fines of US $25,000 each. Ms. Hartford, Mr. Brehl and Mr. Kamienski also agreed to be suspended from practicing before the SEC as accountants with the right to apply for reinstatement. E&Y also agreed to pay a separate fine of US $4.975 million as a result of an “inappropriate close personal relationship” between Gregory Bednar, a former E&Y partner, and the former chief financial officer of another public company that also was an E&Y audit client. Here the SEC cited numerous personal interactions from 2012 through 2014, including events with families and large expenditures on sporting events and other items, that it claimed compromised the independence of E&Y and rendered false E&Y’s representations to the SEC regarding its independent relationship with its client. For example, said the SEC, “[d]uring the relevant period, Bednar and the CFO exchanges hundreds of personal texts, emails and voicemails that did not include meaningful business-related discussions.” To resolve charges also brought against him personally, Mr. Bednar agreed to pay a fine of US $45,000 and likewise consented to be suspended from practicing before the SEC with a right to be reinstated after three years.
  • CME Group Describes Responsibilities of Clearing Members and Globex Order Placers for Tag 50s in Revised Advisory: CME Group updated its guidance related to Tag 50 IDs – identifiers that are used to identify natural persons placing messages (including orders) onto Globex – in order to clarify the responsibilities of clearing members and message placers. Among other things, CME Group reiterated that clearing members are responsible to ensure that all Tag 50 IDs utilized by its customers are unique at the clearing member level, and that all non-administrative messages, including orders, include the correct Tag 50 IDs. CME Group also reconfirmed that registration of Tag 50 IDs through its Exchange Fee System is mandatory for certain persons affiliated with members (including clearing members), as well as all other persons that receive preferential fees from any of the CME Group’s exchanges. CME Group said it is the obligation of clearing members to ensure that all Tag 50 IDs required to be registered are, in fact, registered and updated promptly, as necessary. CME Group indicated that, although not required, clearing members may register the Tag 50 IDs of other individuals or teams. CME Group also said that, in connection with omnibus accounts, clearing members must be able to provide the identity (or to require the relevant omnibus account to obtain and provide the identity) of any individual or team assigned within the omnibus account “promptly upon request by Market Regulation.” Additionally, CME Group's guidance describes the circumstances when a Tag 50 ID should reflect an individual (e.g., a single person who physically submits messages into Globex or is solely responsible for an automated trading system (ATS) at the relevant time) or a team (e.g., a group of persons who are responsible for the administration, operation and monitoring of an ATS at the relevant time).

Compliance Weeds: Each person entering non-administrative messages (including orders) manually or automatically into CME Globex must ensure that the order is accompanied by an operator identification known as a Tag 50 ID. This identification must be unique to the individual entering the order or, in the case of an automated trading system, unique to the person responsible for operating and monitoring the ATS at the time any messages are sent to Globex, or the team of persons on the same shift responsible for the ATS’s operation and monitoring. All Tag 50s must also be unique at the level of the clearing member firm. Individuals and team members may not permit their unique Tag 50s to be used by other persons. Other exchanges have equivalent requirements (e.g., ICE Futures U.S.; click here to access IFUS Rule 27.12(f)). Beginning September 29, 2016, future commission merchants must, under certain circumstances, report to the Commodity Futures Trading Commission on Form 102A or 102B the trading account controllers of their futures trading accounts exceeding reportable position or trading level thresholds (“reportable accounts”). These persons are defined as natural persons who by power or attorney or otherwise actually direct the trading of a trading account. (Click here to access CFTC Regulation 15.00(bb).) However, CFTC staff recently issued a guidance stating that a person “directing trading” is not only a person who provides trading instructions, but a person who implements those instructions. (Click here to access Division of Market Oversight Guidance Regarding the Term “Owner” and “Controller” in the Ownership and Control Reporting (OCR) Final Rule” dated April 8, 2016.) Clients holding reportable accounts are obligated to provide information regarding their account controllers to their FCMs and to amend such information timely, practically on the same day as any change. Firms trading electronically should be mindful of the potential overlap of individuals required to obtain unique identification tags and to be identified to their FCMs as account controllers, and should consider whether it might be helpful to better coordinate the identification of all such relevant persons. (Click here for background on the CFTC’s imminent OCR requirements in the article, “CFTC Again Extends Deadlines for New OCR Compliance; Puts Pressure on FCM Clients Who Will Not Provide Adequate Information Regarding Trading Control” in the April 10, 2016 edition of Bridging the Week.)

  • Alleged EFRP and Wash Sale Violations Are Subjects of CME Group Disciplinary Actions Settlements: CME Group brought and settled disciplinary actions against two firms, including one non-member, for entering into exchange for related position transactions without a corresponding related position. In both cases, one involving Evolution Markets Ltd., a non-member, and the other, involving BNP Paribas Commodity Futures Ltd., a member, the disciplinary actions were filed against the firms in their roles as brokers; the actual parties to the EFRPs were not named. Both firms resolved their disciplinary actions by agreeing to pay a fine of US $15,000. Separately, ED&F Man Capital Markets Inc., a member, and Merit Performance Concepts Ltd., a non-member, also agreed to settle CME Group disciplinary actions that alleged that they impermissibly engaged in EFRPs without a related position as traders. CME Group alleged that ED&F Man entered into “several” such EFRPs, while Merit Performance entered into a single problematic EFRP. ED&F Man agreed to resolve its disciplinary action by paying a fine of US $17,500 while Merit Performance agreed to remit a penalty of US $15,000. Finally, Chenhui Wang, a non-member, agreed to pay a fine of US $20,000 and a 10 business day CME Group all exchange trading suspension in connection with an allegation that on “multiple” days from December 18, 2014, through January 28, 2015, he engaged in wash trades to transfer funds between different accounts he owned and controlled.
  • Federal Reserve Proposes Rule to Severely Restrict Banking Organizations From Commodities Activities: The Board of Governors of the Federal Reserve System proposed a sweeping new rule to severely limit the physical commodity activities of financial holding companies. Principally, the FRB proposed new requirements that would materially increase FHC’s risk-based capital requirements applicable to physical commodities; impose a consolidated organization-wide 5 percent cap on the total value of commodities an FHC may hold compared to its Tier 1 capital; eliminate copper as an approved precious metal that bank holding companies are permitted to own and store; and cancel the authority of five FHCs to engage in energy management and energy tolling activities. The FRB also proposed to require FHCs to report more detailed information regarding their physical commodity activities. The FRB claimed the new rule is necessary because of the “potential environmental catastrophe and other risks associated with physical commodity activities of FHCs.” The FRB will accept comments on its proposal through December 22. Recently, the FRB recommended severely limiting the non-core bank activities that FHCs may engage in, by proposing that Congress repeal the authority of FHCs to invest in non-financial companies as part of a bona fide merchant or investment banking activity (including the authority to make investments in portfolio companies engaged in physical commodity activities) and the grandfathered authority of two FHCs to engage in physical commodity activities directly. (Click here for details in the article, “Federal Reserve Recommends Repeal of Financial Holding Company’s Authority to Invest in Commodity Firms” in the September 11, 2016 edition of Bridging the Week.)
  • Hedge Fund Icon Sued by SEC for Alleged Insider Trading: The Securities and Exchange Commission filed a lawsuit against Leon Cooperman, the president, chief executive officer and majority shareholder of Omega Advisors, Inc., a registered investment adviser, and Omega Advisors, alleging that, in 2010, through his personal holdings and client holdings of Omega Advisors, Mr. Cooperman profited because of trading on insider information he wrongfully obtained. According to the SEC’s complaint, filed in a federal court in Pennsylvania, Mr. Cooperman obtained nonpublic information regarding divestiture plans of Atlas Pipeline Partners, L.P., a company in which he owned or controlled a substantial number of shares. Despite providing assurances to the APL executive who provided him the nonpublic information that he could not and would not trade based on it, he in fact so traded, claimed the SEC. Later, in late 2011 or early 2012 after Omega Advisors was served with a subpoena regarding trading in APL securities, Mr. Cooperman “improperly” sought the executive’s assurances that he “had not shared confidential information with him in advance of the announcement of [the divestiture].” The SEC seeks an injunction, disgorgement of trading profits and a fine against the defendants. In a letter sent to investors, Mr. Cooperman said “[w]e have done nothing improper and categorically deny the Commission’s allegations.”

And more briefly:

  • International Bank Settles With CFTC Over Alleged Failure to Document EFRPs: Barclays Bank PLC agreed to settle charges brought by the Commodity Futures Trading Commission related to its alleged failure to maintain and produce confirmation statements for 1,358 metals and energy exchange for related position transactions it entered into from September 1, 2009, through October 16, 2012. Barclays Bank agreed to pay a fine of US $500,000 to resolve the CFTC’s enforcement action.
  • HK Derivatives Regulator Proposes to Amend Position Limits Regime to Authorize Higher Excess Levels: The Hong Kong Securities and Futures Commission issued a consultation on its proposal to increase the cap on excess position limits that may be granted to exchange participants or affiliates trading Hang Seng Index and Hang Seng China Enterprises Index futures and options contracts. In addition, SFC proposed to enable market makers, and liquidity providers of exchange-traded funds as well as locally authorized asset managers to also apply for higher limits. Traders in Hong Kong are subject to position limits on enumerated derivatives contracts and a large trader position-reporting regime. SFC will accept comments on its proposal through November 21.
  • SFC in Hong Kong Warns of Impending AML Enforcement Proceedings; Urges Brokerage Firms to Enhance Internal Controls: The Hong Kong Securities and Futures Commission advised that it is currently investigating “a number of cases” of SFC licensed brokerage companies with potentially inadequate anti-money laundering internal controls, and that it expects to commence enforcement proceedings in response. Among the areas of concern identified by SFC were failure to analyze cash and third-party deposits into customer accounts; ineffective review of transactions in customer accounts; and failure to consider adequately potentially suspicious transactions to determine whether a suspicious activity report should be filed.
  • ESMA Seeks Views on Mandatory OTC Derivatives Trading Obligation: The European Securities and Markets Authority sought input on how it should best implement the trading obligation for over-the-counter derivatives as contemplated in the Markets in Financial Instruments Regulation (Click here to access Article 32(1).) ESMA believes that the earliest date any trading obligation can be implemented is January 3, 2018, the first date of application of MiFIR. Moreover, ESMA considers that any trading obligation should be aligned with the relevant clearing obligation. Thus, because different categories of counterparties will have different phase-in schedules before they are subject to mandatory clearing for different classes of OTC derivatives, no trading obligation should apply before a respective counterparty is subject to a clearing obligation, proposed ESMA. This will likely necessitate a phase-in over time of the trading obligation, ESMA contemplated. ESMA will accept comments through November 20, 2016. (Click here for further information on ESMA's mandatory trade execution obligations in the article "ESMA Publishes Discussion Paper on Mandatory Trade Execution Obligations for OTC Derivatives Under MiFIR" in the September 23, 2016 edition of Katten Muchin Rosenman LLP's Corporate and Weekly Financial Digest.
  • Canada Proposes Commodity Pool Regulation Update: The Canadian Securities Administrators proposed amendments to existing rules that would move most of the existing Canadian regulatory framework related to commodity pools from a distinct regulation for CPOs to one applicable to all investment funds. At the same time it would replace the term “commodity pool” with the designation “alternative fund” and expand concentration restrictions related to securities of any one issuer within alternative funds from 10 percent of net asset value to 20 percent. In addition, CSA proposed that alternative funds be permitted to invest up to 100 percent of their NAV in any other mutual fund (including other alternative funds) or in nonredeemable investment funds provided the other funds are subject to the same regulation as the investing alternative fund. Currently, in Canada, commodity pools are subject to the same fund of fund investment restrictions as conventional mutual funds. Comments will be accepted by all of the CSAs through December 22.


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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