Bridging the Weeks - April 2018 #3

by Katten Muchin Rosenman LLP

Last week, a broker-dealer was fined US $1.575 million by the Financial Industry Regulatory Authority and other self-regulatory organizations for not complying with market access requirements for gatekeepers, while the Commodity Futures Trading Commission and the Chicago Board of Trade collectively sanctioned a floor broker US $250,000 for purportedly engaging in spoofing trading activities – after being fined for the same type of violation just a few years ago. Meanwhile, the Department of Justice opposed the efforts of the first individual convicted of spoofing under a Dodd-Frank law to have the US Supreme Court hear his appeal. As a result, the following matters are covered in this week’s edition of Bridging the Week:

  • Broker-Dealer Sanctioned US $1.575 Million by FINRA and Other SROs for Market Access Rule Violations (includes Compliance Weeds);
  • CFTC and CBOT Collectively Fine Floor Broker US $250,000 for Alleged Repeat Spoofing Violations (includes Compliance Weeds);
  • US Opposes Effort of Imprisoned Trader to Have Supreme Court Consider Overturning Conviction for Spoofing (includes My View); and more.

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  • Broker-Dealer Sanctioned US $1.575 Million by FINRA and Other SROs for Market Access Rule Violations: Instinet LLC agreed to pay a fine of US $1.575 million to resolve charges by the Financial Industry Regulatory Authority, as well as by five exchanges and certain of their affiliated exchanges, for allegedly violating the Securities and Exchange Commission’s Market Access Rule. The purported wrongful conduct occurred from August 2012 through at least November 2017.

Under Reg MAR – adopted by the SEC in 2010 – broker-dealers with market access, or that provide a customer or any other person with access to an exchange or an alternative trading system, are obligated to have a system of risk management controls and supervisory procedures reasonably designed to manage the financial, regulatory and other risks, including legal and operational risks, related to market access. Reg MAR is intended to prevent the entry of erroneous orders and orders that exceed pre-set credit or capital thresholds by each broker-dealer and each of a broker-dealer's customers (including other broker-dealers, individuals or institutions such as hedge funds) through mandatory pre-order entry checks, and was meant to eliminate so-called "naked access" (e.g., orders not subject to any pre-trade filters). (Click here to access Reg MAR, Rule 15c3-5.)

According to FINRA, during the relevant time, Instinet failed to have adequate risk management controls and supervisory procedures to mange the financial, regulatory and other risks associated with its market access business. FINRA claimed that the firm did not ensure compliance with all its requirements under Reg MAR, including “supervising client trading to detect and prevent potentially violative layering, spoofing and wash trading.”

As an example of the firm’s alleged violations, FINRA claimed that, from August 2012 through January 2014, Instinet maintained an exception report that flagged pre-open placement and cancellation of orders that exceeded 10 percent of a security’s 30-day average volume. However, this exception process failed to identify two customers whose problematic pre-open orders exceeded the firm’s threshold because of a programming error that replaced the comma used as a separator in numbers with a period. Thus, an order for 100,000 shares would be viewed as an order for 100 shares. As a result, Instinet failed to review potentially non-bona fide transactions on 75 instances during the review period.

As part of its settlement, Instinet also agreed to certain undertakings, including filing with FINRA within 90 days a representation that it has implemented controls and procedures reasonably designed to ensure its compliance with Reg MAR.

The five principal exchanges that joined FINRA in its enforcement action were the BOX Options Exchange, LLC, the Cboe BZX Exchange, Inc., Investors Exchange, LLC, The NASDAQ Stock Market, LLC, and the New York Stock Exchange.

Compliance Weeds: In July 2017, four broker-dealers agreed to pay an aggregate fine of US $4.75 million to resolve charges brought by FINRA and various securities exchanges for violating Reg MAR. According to FINRA and the exchanges, the firms failed to comply with one or more provisions of Reg MAR, including not implementing controls to prevent the entry of mistaken or duplicate orders, orders that were in excess of pre-set credit or capital limits or orders that might constitute potentially violative or manipulative orders. (Click here for background in the article “Four Broker-Dealers Agree to Pay Aggregate Fine of US $4.75 Million to FINRA and Various Exchanges for Allegedly Violating SEC Market Access Rule” in the July 30, 2017 edition of Bridging the Week.) Earlier this year, FINRA indicated that compliance with Reg MAR would be a focus of its 2018 examination of members. (Click here for details in the article “FINRA Announces 2018 Examination Priorities; Will Review Role of Firms and Salespersons in Facilitating Cryptocurrency Transactions and ICOs” in the January 15, 2018 edition of Bridging the Week.)

As a result, broker-dealers should routinely review their market access written policies and procedures to double-check they reflect current practices, and examine market access gatekeeper systems to ensure that all relevant customers’ orders are routed through such systems, and that the systems are achieving the purpose for which they were designed. This likely involves reviewing the adequacy of all data feeds and evaluating sample output against input to ensure the output is likely correct.

Both the SEC and FINRA offer extensive resources to help broker-dealers comply with their obligations under Reg MAR. (Click here to access the SEC’s Answers to Frequently Asked Questions related to Reg MAR and here to access Report on FINRA’s Examination Findings (December 2017), section of Market Access Controls (pages 9-10).)

  • CFTC and CBOT Collectively Fine Floor Broker US $250,000 for Alleged Repeat Spoofing Violations: Anuj Singhal settled an enforcement action with the Commodity Futures Trading Commission and a disciplinary action by the Chicago Board of Trade by consenting to pay an aggregate fine of US $250,000 related to purported spoofing trading.

According to the CBOT, on multiple occasions from June 2015 through December 2016, Mr. Singhal entered and cancelled layered orders for wheat and soybean futures contracts on one side of the market to effectuate the execution of small orders on the other side of the market. The CBOT claimed that Mr. Singhal never intended to execute his layered orders.

The CFTC – which based its enforcement action on a smaller period of time (March through June 2016) – alleged the same essential wrongful conduct by Mr. Singhal. However, the CFTC noted that, even after the defendant effectuated the execution of his small orders, “in most instances,” he continued to place and cancel larger orders on the other side of the market.

In 2014, Mr. Singhal settled another disciplinary action brought by the CBOT alleging that he engaged in a “pattern of [spoofing] activity” from June through August 2011 in various agricultural futures contracts. Mr. Singhal resolved this action by payment of a fine of US $60,000 and a three-month all CME Group exchanges’ trading prohibition. (Click here for details in the article “Important Reminders Resonate From Recent CME Group and ICE Futures U.S. Disciplinary Actions” in the September 28, 2014 edition of Bridging the Week.)

To resolve his current CFTC enforcement action, Mr. Singhal agreed to pay a fine of US $150,000 and serve a four-month trading suspension. Mr. Singhal also agreed to pay a US $100,000 penalty and serve a concurrent four-month all CME Group exchanges’ trading prohibition to resolve the CBOT’s disciplinary action.

Mr. Singhal is a CFTC-registered floor broker.

Compliance Weeds: Earlier this year, the CFTC and the Department of Justice coordinated announcements regarding the filing of civil enforcement actions by the CFTC, naming five corporations and six individuals, and criminal actions by the DOJ against eight individuals – including six of the same persons named in the CFTC actions – for engaging in spoofing activities in connection with the trading of futures contracts on US markets. Two of the corporations that resolved their CFTC enforcement actions were Deutsche Bank AG and its wholly owned subsidiary Deutsche Bank Securities Inc.; they agreed to jointly and severally pay a fine of US $30 million. Although the purported problematic trading activity was undertaken by employees of DB, DBSI – a registered futures commission merchant – was named in this action because of its alleged failure to supervise. According to the CFTC, while DBSI maintained a surveillance system that detected many instances of potential spoofing by DB traders, it failed to follow up on “the majority” of potential flagged issues.

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 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 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.”

Both the DBSI and Advantage cases suggest that the CFTC believes that FCMs have some type of oversight responsibility related to their customers’ trading to help ensure market integrity, and must take some appropriate action when they have knowledge of potential wrongdoing.

Accordingly, at a minimum, FCMs should have procedures to internally escalate potential allegations of wrongdoing by customers received from regulators and other third parties, and should consider proactive monitoring of some type on an ongoing basis for trading that may violate the law. The challenge of monitoring, however, is calibrating a system to identify meaningful potential exceptions so as not to be inundated by too many false positives and to ensure that data received and evaluated by the system does not unintentionally exclude any relevant order information. However, all alerts should be reviewed in some manner, and those reliably suggesting potential problematic conduct should be followed up. All monitoring should be documented.

  • US Opposes Effort of Imprisoned Trader to Have Supreme Court Consider Overturning Conviction for Spoofing: The Department of Justice filed a brief with the US Supreme Court opposing Michael Coscia’s prior petition requesting that the Court consider overturning his 2015 conviction for spoofing. The DOJ argued that the anti-spoofing provision of law under which Mr. Coscia was convicted was not void for vagueness, as he had argued. (Click here to access Commodity Exchange Act, 7 U.S. Code § 6c(a)(5).) According to the DOJ, while some orders may be placed with the possibility they may be cancelled prior to execution, they are “designed to be executed upon the arrival of certain subsequent events.” This contrasts with spoofing orders that are prohibited under law, because they “are never intended to be filled at all.” Mr. Coscia was the first person convicted of spoofing under the express prohibition enacted under the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010. (Click here for background regarding Mr. Coscia’s arguments in the article “First Trader Criminally Convicted for Spoofing Requests Supreme Court Overturn Decision, Claims Applicable Statute Is Unconstitutionally Vague” in the February 11, 2018 edition of Bridging the Week.) He was sentenced to three years imprisonment in July 2016. (Click here for details in the article, "Michael Coscia Sentenced to Three Years’ Imprisonment for Spoofing and Commodity Fraud" in the July 27, 2016 edition of Bridging the Week.)

My View: As I have repetitively written, the anti-spoofing provision of law enacted as part of Dodd-Frank is badly drafted because it uses a term that is assumed to be commonly understood and is followed by a parenthetical that is too broad in scope. The law on its face seems clear; it prohibits trading that “is, is of the character of, or is commonly known to the trade as, ‘spoofing’ (bidding or offering with the intent to cancel the bid or offer before execution).” However, this provision fails to reference the totality of the transaction that is potentially problematic – namely the placement of an order with the intent to cancel it prior to its execution to induce the non-bona fide execution of an opposite-side-of-the-market order.

I am still struck that the DOJ’s own criminal complaints alleging spoofing belie that placement of orders and cancelling them alone is problematic – it is that behavior coupled with the intent to execute opposite-side-of-the-market orders initially away from the prevailing best bid and offer that is wrongful. (Click here for background in the article “CFTC Names Four Banking Organization Companies, a Trading Software Design Company and Six Individuals in Spoofing-Related Cases; the Same Six Individuals Criminally Charged Plus Two More” in the February 4, 2018 edition of Bridging the Week.)

Now it’s up to the Supreme Court to decide.

More Briefly:

  • Texas Study Finds Extensive Fraud in Cryptocurrency ICOs: The Texas Securities Board issued a report noting widespread fraud in connection with many cryptocurrency offerings aimed at the state’s citizens. For example, the Board indicated that, in connection with 32 investigations opened during a four-week period beginning December 18, 2017, no promoter was registered to sell securities in Texas, only 11 promoters provided a physical address, and 5 promoters guaranteed returns. To date, the Board has taken legal actions against seven of the promoters.
  • SEC OCIE Identifies Most Frequent Advisory Fee and Expense Compliance Issues Found in Investor Adviser Examinations: The Securities and Exchange Commission’s Office of Compliance Inspections and Examinations issued an overview of the “most frequent” advisory fee and compliance issues that it came across during examinations of investment advisers. Among other issues, OCIE found examples of fee-billing based on incorrect account valuations or omitting rebates, billing fees at unauthorized time intervals or using incorrect rates, and actual billing practices that were inconsistent with Form ADV disclosures. OCIE also found that, on occasion, advisers to private and public funds incorrectly allocated certain expenses to funds, contrary to applicable advisory agreements, operating agreements or other disclosures.
  • CFTC Chairman Muses Morally About Markets: J. Christopher Giancarlo, Chairman of the Commodity Futures Trading Commission, spoke about a moral approach to market regulation during a lecture at Concordia College in New York last week. First and foremost, Mr. Giancarlo suggested that the Golden Rule should apply to marketplaces – “we should each treat each other in the marketplace with the respect and regard we want for ourselves, with business practices that we want for ourselves.” That being said, Mr. Giancarlo indicated that market regulators should not limit economic freedom “without serious justification.” However, “regulators [must] vigorously protect market integrity by enforcing the laws that ensure it.”
  • ICE Futures US to Authorize Traders to Enter New RFQs Even When RFQs Related to Crossing Orders Are Pending: ICE Futures U.S. proposed amendments to its rules and a guidance to permit persons to enter a request for quote in connection with a block trade or cross trade when another RFQ for such purposes is pending. Currently, a person may not enter another RFQ for five seconds after another RFQ is placed and pending. However, entering a new RFQ while one is pending to distract other market participants from the pending RFQ will be prohibited. The new rules will be effective April 23, absent objection by the Commodity Futures Trading Commission.
  • FINRA Announces VIX-Linked Product Review: The Financial Industry Regulatory Authority announced that it is conducing a review to assess member firms’ practices related to recommendations made to non-institutional clients related to Cboe Volatility Index products. An unnamed whistleblower recently alleged that unnamed persons might be manipulating VIX-based products because of an alleged flaw in the contract’s design. (Click here to access a copy of a letter containing the allegations.)
  • SEC Confirms Third-Party Recordkeeping Retention Agreements That Provide for Deletion or Discarding Documents in Case of Broker-Dealer Non-Payment Are Not Permitted: The Securities and Exchange Commission’s Division of Trading and Markets issued a letter noting that broker-dealers could not delegate their recordkeeping obligations to third parties who contractually were entitled to “delete or destroy” records for non-payment. Generally, third-party recordkeepers must file a written undertaking with the SEC acknowledging that records are the property of the broker-dealer that the broker-dealer is required to preserve. Third-party entities that delete or destroy records may be subject to secondary liability for causing a recordkeeping violation by the broker-dealer, said the SEC.

For further information:

Broker-Dealer Sanctioned US $1.575 Million by FINRA and Other SROs for Market Access Rule Violations:

CFTC and CBOT Collectively Fine Floor Broker US $250,000 for Alleged Repeat Spoofing Violations:

CFTC Chairman Muses Morally About Markets:

FINRA Announces VIX-Linked Product Review:

ICE Futures US to Authorize Traders to Enter New RFQs Even When RFQs Related to Crossing Orders Are Pending:



SEC OCIE Identifies Most Frequent Advisory Fee and Expense Compliance Issues Found in Investor Adviser Examinations:

SEC Confirms Third-Party Recordkeeping Retention Agreements That Provide for Deletion or Discarding Documents in Case of Broker-Dealer Non-Payment Are Not Permitted:

Texas Study Finds Extensive Fraud in Cryptocurrency ICOs:

US Opposes Effort of Imprisoned Trader to Have Supreme Court Consider Overturning Conviction for Spoofing:


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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Katten Muchin Rosenman LLP

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