Will the fourth time be the charm? This week, the Commodity Futures Trading Commission will try for the fourth time since 2011 to revise its speculative position limits rules. Details have not been made public, but Heath Tarbert, the CFTC's Chairman, suggested last week that the proposed amended rules will provide for "flexible" bona fide hedging exemptions. Separately, the CFTC's Division of Enforcement and a programmer sued by the Commission for allegedly aiding and abetting spoofing activities of a trader have agreed on terms to end the enforcement action. However, the full Commission must approve the settlement to be binding; this apparently may take up to three months. To date, the agreed terms have not been made public. As a result, the following matters are covered in this week’s edition of Bridging the Week:
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Legal Weeds: In November 2013, the CFTC proposed new rules related to derivatives speculative position limits, addressing absolute levels for 28 so-called “core referenced futures contracts” involving various agricultural commodities, energy products and metals. These limits were proposed to apply on a futures-equivalent basis across all referenced contracts (e.g., related futures, options and swaps). The proposed rules also addressed what constituted bona fide hedging positions. The recommended rules were meant to replace final rules adopted by the CFTC in 2011 that were vacated by a US district court in September 2012. (Click here for details regarding the CFTC’s 2013 proposed position limit rules in the article “CFTC Proposes Revised Position Limit Rules” published on November 12, 2013, by Katten Muchin Rosenman LLP.)
In May 2016, the CFTC proposed some modifications and additions to its 2013 proposed regulations and guidance related to speculative position limits in order to potentially authorize relevant derivatives exchanges to recognize certain derivatives positions as constituting non-enumerated bona fide hedges or enumerated anticipatory hedges. The CFTC also proposed to grant derivatives exchanges authority to recognize certain spread positions as justifying an exemption from speculative position limits too. (Click here for background in the article “CFTC Proposes to Authorize Exchanges to Grant Physical Commodity Users Non-Enumerated Hedging Exemptions and Other Relief Related to Speculative Position Limits” in the May 27, 2016 edition of Between Bridges.)
In December 2016, the CFTC re-proposed its position limits rules. Compared to its November 2013 proposed rules, the Commission’s most recent proposals: (1) reduced the number of core referenced contracts subject to express oversight by the Commission for position limits purposes from 28 to 25; (2) revised spot month, single and all-months position limits on the 25 referenced contracts; (3) defined bona fide hedging to more closely parallel the definition in existing law and to address many concerns raised in response to the CFTC’s 2013 proposal; and (4) authorized persons to apply for non-enumerated hedging exemptions from qualified exchanges, even for referenced contracts. (Click here for background in the article “CFTC Adopts Final Rules Related to Aggregation of Positions and Owned Entity Exemption; Re-Proposes Position Limits Rules” in the December 11, 2016 version of Bridging the Week.)
Following adoption of the Dodd Frank Wall Street Reform and Consumer Protection Act, the CFTC first proposed amendments to its position limits regime on January 26, 2011. (Click here to access the relevant Federal Register announcement.)
In January 2018, the CFTC charged Mr. Thakkar and Edge Financial with aiding and abetting both spoofing and engaging in a manipulative and deceptive scheme for designing software that was used by Navinder Sarao to engage in spoofing involving E-mini S&P futures contracts traded on the Chicago Mercantile Exchange from January 30 through October 30, 2013. Mr. Sarao pleaded guilty to criminal charges of spoofing, and settled a CFTC civil suit related to the same offenses in November 2016. (Click here for background regarding Mr. Sarao’s settlements 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.)
According to the CFTC, Mr. Thakkar and Edge Financial aided and abetted Mr. Sarao’s spoofing by designing a custom “Back-of-Book” function. This function automatically and continuously modified the trader’s spoofing orders by one lot to move them to the back of relevant order queues (to minimize their chance of being executed) and cancelled all spoofing orders at one price level as soon as any portion of an overall order was executed. The CFTC said that Mr. Sarao used the Back-of-Book function to engage in his illicit activities. (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.)
Although the DOE and defendants agreed to terms, they requested the relevant court to stay all proceedings for three months to formally resolve the enforcement action. This is because, among other things, the DOE cannot bind the CFTC to a negotiated consent order without first obtaining approval “from the five CFTC commissioners.” To accommodate this, the DOE and defendants requested that deadlines for all discovery and motions be suspended.
The relevant court – the United States District Court sitting in Chicago – is expected to hear the parties on their request on January 28.
Legal Weeds: At the same time the CFTC filed its civil case against Mr. Thakkar and Edge Financial, Mr. Thakkar was also named in a criminal complaint related to the same conduct. He was charged with conspiracy to commit spoofing as well as aiding and abetting spoofing.
Subsequently, the criminal charges against Mr. Thakkar for conspiracy to commit spoofing were dismissed by the judge presiding over Mr. Thakkar’s criminal trial. Shortly afterwards, the same judge declared a mistrial after the jury failed to reach an unanimous verdict on the charge of aiding and abetting spoofing. The Department of Justice declined to retry Mr. Thakkar. (Click here for background regarding Mr. Thakkar’s criminal proceedings in the article “Department Declines to Retry Alleged Programmer for Flash Crash Spoofer” in the April 29, 2019 edition of Bridging the Week.)
Following these events, the CFTC determined to proceed with its civil action against defendants. In a memorandum filed in support of a motion summary judgment, defendants argued that, as established at Mr. Thakkar’s criminal trial, they “did not know Sarao would use the computer program Edge Financial developed to engage in illegal trading, and [defendants] did not intend to further Sarao’s illegal trading.” (Click here for background in the article “Purported Programmer for Flash Crash Spoofer Moves for Summary Judgment in CFTC Enforcement Proceeding” in the September 9, 2019 edition of Bridging the Week.) The court declined to grant defendants’ motion as premature. (Click here for more information in the article “Court Denies Summary Judgment Motion of Purported Programmer for Flash Crash Spoofer” in the September 15, 2019 edition of Bridging the Week.)
As a result of the CFTC’s persistence in prosecuting him, Mr. Thakkar has become somewhat of a folk hero. As of January 24, 2,511 persons have signed a petition requesting that the CFTC drop its civil charges against him and apologize (click here for background), and John Lothian News – a widely read derivatives industry publication – has passionately advocated for Mr. Thakkar in multiple commentaries (click here for examples).
This article was amended on January 27 to reflect that Mr. Sarao settled his criminal and civil regulatory actions in 2016 and not 2018 as erroneously reflected in an earlier edition.
Both organizations generally disputed the SEC’s position that Gram digital tokens intended to be delivered pursuant to the terms of investment contracts sold by the defendants in 2018 to so-called accredited investors under a lawful exemption from registration requirements were, in fact, securities. The organizations said the SEC’s view incorrectly confused the initial offering with the referenced underlying asset and in doing so, left uncertain which digital assets generally might be securities, hindering development of an emerging technology and opportunities for societal benefits. The organizations claimed that the SEC has given unhelpful guidance regarding its position, and has mostly regulated arbitrarily through enforcement.
My View: The SEC’s views in its own motion for summary judgment are significantly undercut by its reliance on guidance related to private offerings and securities that precedes the blockchain era as opposed to more recent statements by its own leaders, let alone the extensive April 2019 Framework for “Investment Contract” Analysis of Digital Assets published by the SEC's Strategic Hub for Innovation and Financial Technology. These more current commentaries acknowledge the distinction between an offering and the subject of an offering, and note that the nature of the offering (e.g., how is it sold and to whom) may transform the offering into a security, but it doesn’t necessarily affect the nature of the subject of the offering. In the 1946 landmark Supreme Court decision, SEC v. Howey Co., the sale of orange groves which was deemed to be a securities offering did not transform the underlying oranges into securities. They remained consumable fruit. (Click here for background in the article “SEC Staff Outlines Characteristics of Cryptoassets That Could Cause Them to Be Regarded as Securities” in the April 7, 2019 edition of Bridging the Week. Click here to access the Howey Co. decision.)
Moreover, more recent commentaries by SEC staff have acknowledged that not all digital assets are securities and that the nature of a digital asset can morph over time. Ether, for example, might have been deemed a security at one time, but is a virtual currency today. (Click here to access an overview of SEC Director of Corporation Finance William Hinman’s view of the nature of cryptoassets and offerings of digital tokens in the article “Anything But Sleep Inducing: SEC Corporation Finance Director Says Ether Not a Security and Canada Issues Guidance on Utility Tokens” in the June 17, 2018 edition of Bridging the Week.)
The SEC’s rationale to bring an enforcement action against Telegram and TON is unclear at best and appears inconsistent with its staff’s own recent pronouncements. Objectively, it appears the defendants endeavored carefully to navigate a path to securities law compliance by bifurcating their offering between an exempt private sale of an investment contract and a subsequent public dissemination of a virtual currency, choosing as the demarcation line the date on which the Gram blockchain would be functional. This appears parallel to the path of ether and consistent with the fairest reading of the murky guidance out there. This lawsuit blasts more frigid air on an already freezing environment and will further chill entrepreneurs who seek to develop and introduce innovative applications utilizing blockchain technology (Click here to access SEC Commissioner Hester Peirce's views of the Framework in the article "SEC Crypto Guidance Employing Jackson Pollock Techniques Too Cryptic Says Commissioner Hester Peirce" in the May 12, 2019 edition of Bridging the Week.)
In July 2019, the CFTC’s Divisions of Swap Dealer and Intermediary Oversight and Clearing and Risk issued a no-action letter authorizing derivatives clearing organizations to permit their FCM clearing members carrying multiple accounts for the same beneficial owner to treat each account as an account of a separate entity for purposes of disbursements under ordinary circumstances, subject to enumerated terms and conditions. Specifically, an FCM could remit funds back to a customer from an over-margined account, while another account of the same customer was subject to a margin call. However, this authority is scheduled to expire on June 30, 2021, in order to give the Commission “time to determine whether to conduct, and if so, to in fact conduct, a rulemaking to implement appropriate relief on a permanent basis.” (Click here for background in the article “One + One No Longer Equals One – CFTC Staff Offers Path for FCMs to Treat Separate Accounts of Single Customer as Separate Accounts of Distinct Entities” in the July 14, 2019 edition of Bridging the Week.)
Claiming that the lack of legal certainty as to permissible market practices under the NAL and the pending expiration date was effectively a Damoclean sword hanging over FCMs, certain commercial enterprises, institutional customers who allocate assets to investment managers pursuant to investment management agreements, and others, FIA and ICUS filed two separate petitions for rulemaking. One proposed mostly to codify the terms of the NAL while the other recommended amending the CFTC’s current prohibition on FCMs guaranteeing customers against losses (see CFTC Rule 1.56(b)) to expressly authorize such brokers to enter into agreements with customers that would limit recourse to the assets under management by a person that a customer has authorized to control trading in an account subject to heightened risk management requirements.
FIA and ICUS said they filed their petitions for rulemaking to encourage public comment on these “important issues.”
CME Group did not join FIA and ICUS in their petitions for rulemaking on this matter.
Legal Weeds: In May 2019, the futures industry’s Joint Audit Committee issued two reminders to FCMs, one regarding the prohibition against making guarantees against loss contained in CFTC Rule 1.56(b), and the other mandating aggregation of all accounts of the same beneficial owner for the same regulatory account classification (e.g., customer segregated, customer secured and cleared swaps customer) for margin purposes, as previously advised by JAC in May 2014. (Click here for background regarding the JAC’s May 2019 regulatory alerts in the article “Futures Industry Self-Regulators Warn FCMs Against Limiting Losses of Customers and Not Combining Accounts for Aggregate Margin Call Calculations” in the May 19, 2019 edition of Bridging the Week. Click here to access JAC Regulatory Alert 14-03.)
The NAL reiterated JAC’s reminder regarding guarantees against loss, but modified JAC’s instructions on the handling of different accounts of the same beneficial owner for margin purposes.
In response, the JAC deemed its May 2019 reminder regarding the margining of different accounts of the same beneficial owner amended by the terms of the NAL. (Click here to access JAC Regulatory Alert 19-02.)
Subsequently, the JAC extended its authorization for FCMs to separately margin multiple accounts of individual customers to separate accounts containing foreign futures and options (Part 30.7 accounts), consistent with the NAL. (Click here for background in the article “Futures SRO Group Extends CFTC Margining Relief for Separate Accounts to Foreign Futures and Options” in the September 9, 2019 edition of Bridging the Week.)
On September 13, 2019, the directors of DCR and DSIO issued a joint statement stating their belief that language in the NAL regarding the required authority of FCMs to "ultimately" look to funds in other accounts of a beneficial owner including accounts that may be under common control was not inconsistent with language in a JAC release that required FCMs "at all times" to have such authority (click here to access the relevant JAC Release 19-03). The directors also extended the compliance date for implementation of the terms and conditions in the NAL to September 15, 2020. (Click here to access the directors' joint statement.)
Notwithstanding, some FCMs have claimed that, because of special reviews being conducted by CME’s Financial and Regulatory surveillance staff, they feel pressured to immediately comply with all terms and conditions of the NAL as opposed to by the September 15 compliance date set forth in the directors' joint statement and worry about the consequences of noncompliance. As a result, some FCMs believe they are diverting limited resources from other pressing regulatory obligations in order to complete compliance with the terms and conditions of the NAL prematurely.
Separately, Propex entered into a non-prosecution agreement with the Department of Justice in which it also agreed to pay US $1 million for the same essential offenses.
The DOJ by name and the CFTC by anonymous reference indicated that Propex’s liability derived from the trading activities of a former trader, Jionsheng (Jim) Zhao, who entered “thousands” of large buy and sell orders in E-mini S&P futures contracts traded on the Chicago Mercantile Exchange without any intent to execute them. Mr. Zhao was the subject of a CFTC lawsuit for spoofing and engaging in a manipulative and deceptive scheme filed in January 2018; he was also criminally charged for the same transactions. (Click here for details 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.) Mr. Zhao pleaded guilty to his criminal charges in January 2019 (click here for background).
The CFTC’s and DOJ’s penalty against Propex is divided into a fine (US $462,271), restitution (US $464,300) and disgorgement (US $73,429). Any amount of penalty paid to the DOJ will satisfy Propex’s obligation to pay the CFTC. Both the CFTC and DOJ noted Propex’s remedial efforts in resolving their actions.
Separately, Deutsche Bank Securities Inc. consented to pay a fine of US $22,500 to resolve charges that it failed to accurately report open interest to the Options Clearing Corporation on four days prior to the final settlement date of the February 2019 VIX futures contract. DB was a CFE trading privilege holder and clearing member during the relevant time.
For further information:
CBOE Futures Exchange Accepts Settlements of Disciplinary Actions Charging Wash Trades and Errors in Open Position Reporting:
CFTC and Programmer Charged With Helping Admitted Spoofer Agree to Suspend Enforcement Action Proceeding to Finalize Settlement:
FIA and ICE Clear U.S. Seek Amended CFTC Rules Related to Margining Separate Accounts of Same Owner:
Four Times a Charm?; CFTC Scheduled to Issue New Position Limits' Proposal on January 30:
ICE Futures U.S. Proposes to Extend Jurisdiction Too:
Industry Groups Seek to File Friend of Court Briefs to Support Online Messaging Company’s Motion for Summary Judgment in SEC Enforcement Action Charging Illegal ICO:
Non-US Company Settles CFTC Enforcement Action Charging Spoofing and Enters Into Non-Prosecution Agreement With DOJ: