The US Department of Justice vehemently opposed the request for a new trial by the first person charged, convicted and sentenced under the Dodd-Frank Wall Street Reform and Consumer Protection Act’s prohibition against spoofing. According to the government, the defendant’s new evidence purportedly supporting a retrial could have been obtained before his trial’s end. Separately, the Securities and Exchange Commission settled allegations against the issuer of a new digital token the SEC said engaged in an unregistered securities offering even though the stated purpose of the cryptoasset was for payment of transactions on a new blockchain-enabled cybersecurity service. However, the SEC demanded no fine to resolve this matter because, among other reasons, the issuer had voluntarily turned itself in. As a result, the following matters are covered in this week’s edition of Bridging the Week:

• Government Argues New Trial for Convicted Spoofer Not Justified by Data Available Before Trial End (includes Compliance Weeds);

• ICO Promoter Settles SEC Enforcement Action for No Fine After Self-Reporting Potential Securities Law Violations (includes Legal Weeds); and more.

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• Government Argues New Trial for Convicted Spoofer Not Justified by Data Available Before Trial End: The United States Attorney for the Northern District of Illinois opposed Michael Coscia’s January 2019 request for a new trial to reconsider whether he engaged in spoofing in violation of the prohibition against such conduct under the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. Mr. Coscia was the first person charged, convicted and sentenced for spoofing under Dodd-Frank.

Mr. Coscia argued that a retrial was warranted because, in his initial hearing, the government had claimed that his pattern of trading was “unique and extraordinary.” However, said Mr. Coscia, the trading data utilized by the Department of Justice during the trial to support the claim was for a “narrow, incomplete set of dates, futures and traders.” Only after his trial, stated Mr. Coscia, did CME Group and the Intercontinental Exchange produce broader sets of data that showed that the ratio of his canceled orders to executions was not unusual and that his “trading activity was the same as hundreds of other traders.” 

The US Attorney observed, however, that Mr. Coscia only requested the trading data after the conclusion of his first trial and has not shown “that this information was previously unavailable through pretrial due diligence.” Moreover, Mr. Coscia raised the same argument during his sentencing and it was rejected, argued the US Attorney.

The US Attorney also alleged that Mr. Coscia proposed to use the new data solely to impeach certain trial exhibits, and new evidence to impeach trial evidence is insufficient to justify a new trial.

Mr. Coscia was sentenced to three years’ imprisonment for spoofing and commodity fraud following a criminal trial in 2015 for three months of trading activity in 2011; he previously settled civil charges related to the same matter with the Commodity Futures Trading Commission, the Financial Conduct Authority, and certain CME Group exchanges. (Click here for background in the article “Michael Coscia Sentenced to Three Years’ Imprisonment for Spoofing and Commodity Fraud” in the July 17, 2016 edition of Bridging the Week.) 

Separately, the Futures Industry Association filed an additional friend of the court brief in connection with the pending criminal case against James Vorley and Cedric Chanu charging them with wire fraud in connection with purported spoofing activity. As the US Chamber of Commerce, the Bank Policy Institute and the Securities Industry and Financial Markets Association stated in their friend of the court brief filed on February 9, 2019, FIA argued that prosecuting defendants for wire fraud (and not spoofing) raised issues of concern to the business community, because such action implied that orders entered without an intent of execution for any reason constituted fraudulent statements to the marketplace. However, observed FIA, such a view would challenge “the vitality of the established legal precept” that market participants have no obligation to disclose any information in connection with open orders including their intentions regarding such orders. 

According to FIA, criminalization of “a market participant’s failure to disclose trading intentions opens the door for arbitrary prosecutions and vexatious private claims.” (Click here for background regarding Mr. Vorley’s and Mr. Chanu’s criminal prosecution as well as the prior amicus brief filed by three industry organizations in the article “Metals Trader Settles CFTC Action for Purported Spoofing After Prevailing in Related Criminal Action” in the February 17, 2019 edition of Bridging the Week.)

Compliance Weeds: As I have observed previously, although most focus has been directed on Dodd-Frank’s and exchanges’ prohibition against placing an order without the intent at the time of order placement for the order to be executed (e.g., “spoofing”), market participants must pay equal attention to exchanges’ prohibition against persons entering or causing the entry of order messages with the intent to disrupt or with reckless disregard for the consequences of such messages on the orderly trading of a market. (Click here to access CME Group Rule 575.D. and here for ICE Futures U.S. Rule 4.02(l)(1)(C) and (D).) Exchanges have used this prohibition to prosecute traders for:

• purportedly misusing user-defined spreads (click here to access the article “CME Group Resolves Two Disciplinary Actions Alleging Market Disruption” in the October 1, 2017 edition of Bridging the Week);

• trading in an alleged disruptive fashion at a contract’s termination (click here to access the article “Two Firms Settle With CME Group Exchanges for Not Supervising Employees Who Allegedly Engaged in Disruptive Trading Practices” in the September 10, 2017 edition of Bridging the Week); and

• supposedly testing the liquidity of a market (click here to access the article “CME Group Exchanges Charge One Trader With Impermissibly Entering Orders To Test Gold Market Latency and Another With Failure to Timely Complete Delivery” in the June 4, 2017 edition of Bridging the Week).

CME Group has also brought a disciplinary action against a non-US brokerage entity for liquidating customers’ orders following non-payment of margin calls without considering the impact of the liquidation on market prices. (Click here to access the article “CME Group Settles Disciplinary Action Alleging That Automatic Liquidation of Under-Margined Customers’ Positions By Non-US Futures Broker Constituted Disruptive Trading” in the March 20, 2017 edition of Between Bridges.)

• ICO Promoter Settles SEC Enforcement Action for No Fine After Self-Reporting Potential Securities Law Violations: Gladius Network LLC settled allegations by the Securities and Exchange Commission that its initial coin offering of GLA tokens intended to be used as the currency for its blockchain-enabled cybersecurity service constituted an offering of unregistered securities in violation of applicable law. Although Gladius’s Terms and Conditions of Token Sale expressly noted that GLA tokens were “not being structured or sold as securities or any other form of investment product,” the SEC said that the firm’s principals and agents discussed the prospects for investment returns from GLA tokens on various social media; Gladius took steps to have GLA tokens traded on significant digital asset trading venues; and Gladius pronounced after the ICO that it entered into a “partnership” to list GLA tokens on “one of the top cryptocurrency exchanges in the world.” 

As a result, said the SEC, purchasers of GLA tokens “would have reasonably expected that they could obtain a future profit from GLA [t]okens if the entrepreneurial and managerial efforts of Gladius’s founders, employees and agents succeeded” regardless of whether they ever used the Gladius service. The SEC said that GLA tokens were, therefore, securities relying on the Supreme Court’s 1946 decision, SEC v. W.J. Howey (click here to access).

The SEC did not charge that Gladius committed any fraud in connection with its ICO.

To resolve the SEC’s allegations, Gladius agreed to register GLA tokens as a class of security and compensate investors, among other undertakings. However, the SEC imposed no fine on Gladius because of the firm’s remedial steps, including its self-reporting of a possible securities law violation and cooperation with SEC staff. 

In November 2018, the SEC filed and settled two enforcement actions against issuers of ICOs – Carrier EQ Inc. d/b/a/ AirFox and Paragon Coin, Inc. – for violating securities registration requirements. These cases represented the first time the SEC assessed fines in connection with a non-fraudulent ICO.

At the same time it published the AirFox and Paragon settlement orders, the SEC’s Divisions of Corporation Finance, Investment Management and Trading and Markets issued a “Statement of Digital Asset Securities Issuance and Trading” that, among other things, noted that the two settlements provided a “path to compliance” for prior issuers of unregistered or not lawfully exempt cryptosecurities. (Click here for background regarding the SEC’s Divisions’ statement as well as the AirFox and Paragon settlement in the November 18, 2018 edition of Bridging the Week.)

In other legal and regulatory developments involving cryptoassets:

• Person Claiming to Be Satoshi Nakamoto Among 34 Responders to CFTC RFI Regarding Ether: The Commodity Futures Trading Commission received 34 letters in response to its December 2018 request for information related to ether – the cryptocurrency designed as the “fuel” of the Ethereum blockchain network – including from one individual – Craig Wright – who claimed to be Satoshi Nakamoto, the developer of bitcoin. Few of the commentators addressed all of the CFTC’s 25 asked questions, but many persons addressed the planned migration of Ethereum from its current proof of work to proof of stake consensus mechanism and whether POS has any “particular vulnerabilities.” FIA Principal Traders Group for example, conjectured that all POS methods “run some risk of becoming more centralized entities where a few participants conduct the lion’s share of verifying transactions.” Coin Desk acknowledged that “the chance of validating a block will be proportional to staked wealth,” but said that this is not a vulnerability but the “intent” of the protocol design. Moreover, the public nature of a blockchain would mitigate against an attacker that presents an alternative history (e.g., to cause a double-spend) and, in any case, a POS system can be designed to forbid block reorganizations beyond more than a certain number of prior blocks and to punish wrongdoers. The Ethereum Foundation expressly noted that, in designing Ethereum’s POS, developers are “taking measures to ensure that proof of stake favors smaller and more decentralized participants” including imposition of an “anti-correlation penalty” against persons who appear to be trying to gang together in highly correlated activity.

The person claiming to be Satoshi Nakamoto offered that “Ethereum is a poorly designed copy of bitcoin designed with the purpose of completing the promise of smart contracts and scripting that were delivered within bitcoin but which were hobbled by the core developers of bitcoin who sought to enable anonymous transactions to exist within the system.”

• ISDA Provides Guidance for Programming Smart Contracts to Effectuate OTC Derivatives Master Agreement: The International Swaps and Derivatives Association issued its second paper offering legal guidelines for smart contracts, stressing certain key elements of the ISDA Master Agreement that should be preserved when developing technological applications. However, ISDA does not believe that all provisions of the ISDA Master Agreement are “well suited or efficient to code.” In its paper, ISDA provides specific technological considerations for provisions dealing with events; payments and deliveries, close out and netting; disputes; and contract formation and legal relations. Among other things, ISDA recommends that, to anticipate the possibility that the commercial intent of the parties may not be accurately reflected in code, a smart contract should include a provision stating that the “natural language version of the contract will prevail in the event of any inconsistencies.”

Legal Weeds: Oral arguments are scheduled for March 13, 2019, in the Commodity Futures Trading Commission’s appeal of the decision of a US district court in California, dismissing its enforcement action against Monex Deposit Company and other defendants. In 2017, the CFTC charged Monex with engaging in illegal off-exchange futures transactions because it entered into leveraged transactions to retail persons without making actual delivery within 28 days, and with committing fraud, relying on authority under the Dodd-Frank Wall Street Reform and Consumer Protection Act. The oral argument will be held at the US Ninth Circuit Court of Appeals sitting in San Francisco.

The district court rejected the CFTC’s legal theories, holding that actual delivery of precious metals in financed transactions to retail persons falls outside the CFTC’s jurisdiction when ownership of real metals is legally transferred to such persons within 28 days. This is the case even if the seller retains control over the commodities because of financing beyond 28 days. The court also held that the CFTC cannot use the Dodd-Frank enacted prohibition against persons engaging in any manipulative or deceptive device or contrivance in connection with the sale of any commodity in interstate commerce to prosecute acts of purported fraud except in instances of fraud‑based market manipulation. (Click  here for background on the district court’s decision in the article “California Federal Court Dismissal of CFTC Monex Enforcement Action Upsets Stable Legal Theories” in the May 6, 2018 edition of Bridging the Week.)

In its appeal, the CFTC argued that the district court was wrong on the law in its analysis of both provisions.

First, the CFTC argued that the Dodd-Frank provision prohibits the type of fraud it charged. (Click here to access the relevant provision of law, 7 U.S.C § 9(1).) The Commission said the district court came to its incorrect conclusion by rewriting the statute (i.e., saying that “manipulative or deceptive device” should be read as “manipulative and deceptive device”). However, this is inconsistent with the intent of Congress in drafting this provision which was to mimic the anti-fraud provision of the Securities and Exchange Commission (Click here to access SEC Rule 10b-5).

Second, the Commission said that the phrase “actual delivery” in the relevant statute means the “formal act of transferring something” and must involve “a transfer of possession and control.” The CFTC argued that Monex’s purported delivery only involved a bookkeeping entry and provided no control to customers – until they repaid the amount they borrowed to purchase or sell the commodity. Accordingly, the Commission had jurisdiction to bring its enforcement action. (Click here to access the relevant provision of law, 7 U.S.C § 2(c)(2)(D)(ii)(III).)

The outcome of this appeal with have implications beyond the precious metals industry as the CFTC employs its § 9(1) authority broadly, and has used the actual delivery provision of law to prohibit leveraged trading involving cryptocurrencies on non-registered exchanges. (Click here for background in the article “Bitcoin Exchange Sanctioned by CFTC for Not Being Registered” in the June 5, 2015 edition of Bridging the Week.)

More Briefly:

• SEC Proposes Authorizing Pre-IPO Communications with Enumerated Sophisticated Investors: The Securities and Exchange Commission proposed a new rule to promote new investments in publicly registered companies. Under the proposed rule, issuers could communicate orally or in writing with investors in new registered securities offerings that are or believed to be qualified institutional buyers or institutional accredited investors before or after the filing of a registration statement related to such offerings. This new rule is an expansion of the “test-the-waters” exemption to applicable securities laws given to emerging growth companies under the 2012 Jumpstart Our Business Startups (“JOBS”) Act. The SEC will accept comments for 60 days after the proposed rule is published in the Federal Register. (Click here for background regarding the JOBS Act.)

• Stock Exchange Sanctions Trading Firm for Alleged Market Access Control Violations: Lime Brokerage LLC – an agency-only broker-dealer that provides technology and market access to its customers – agreed to pay a combined fine of US $625,000 to resolve charges by NYSE Arca, Inc., NYSE LLC, and NYSE American LLC (collectively “NYSE”) for allegedly violating applicable securities laws and exchange rules regarding market access and supervision from November 2013 through May 2018. (Click here to access SEC Rule 15c3-5 – the Market Access Rule.) According to NYSE, during the relevant time, Lime failed to adequately supervise its business and customers by not setting reasonably designed preset credit limits, implementing adequate pre-trade controls, or monitoring customer trading activity for potential manipulative activity. Among other things, one client was approved for a US $500 million credit limit; however, because Lime’s controls did not account for clients trading through multiple “trading clusters,” the client was inadvertently allowed a US $2 billion limit because it was authorized to trade through four clusters. Moreover, despite Lime employees raising this matter to senior staff in compliance and business – including one person terming this an “urgent problem” – the firm did not begin to roll out a solution to this problem until six months later. In addition to imposition of a fine, the firm agreed that, within 90 days of the sanction’s settlement date, it will fix its credit limit, pre-trade controls, and supervisory issues.

• Purported Trade Practice Violations Subject of CME Group Disciplinary Actions: The Chicago Mercantile Exchange sanctioned LLC Insurance Company Respect and Sergey Kondrashev, nonmembers, for allegedly engaging in wash trades on various days in June 2017. Separately, CME found that LLC failed to supervise Mr. Kondrashev to ensure his compliance with exchange rules. According to CME, Mr. Kondrashev executed E-Mini C2500 futures contracts on the Globex trading platform knowing that buy and sell orders for his firm’s accounts would execute opposite each other. Additionally, said CME, Mr. Kondrashev used Tag 50 user IDs of the firm’s other traders to effectuate his trades, in violation of CME rules. Mr. Kondrashev agreed to settle his charges by paying a fine of US $10,000 and incurring a 15-day all CME Group exchanges’ trading ban. LLC additionally agreed to pay a fine of US $40,000. 

Separately, Nomura Securities International, Inc., a member firm, agreed to pay a fine of US $30,000 to resolve charges by the Chicago Board of Trade for allegedly violating exchange for related position transaction requirements and wash trade rules. According to CBOT, on November 9, 2017, the firm executed two exchange for physical transactions in the 2-Year Treasury Note futures market by simultaneously exchanging futures positions without exchanging related cash positions. Additionally, CBOT found that the firm made trades between accounts with common beneficial ownership knowing that the trades would eliminate market risk. 

Finally, CBOT brought and settled a sanction against Songke Wei for prohibited trading practices from October 31, 2016, through October 5, 2017. During the relevant time period Mr. Wei executed round-turn transactions in a number of illiquid oats futures contracts between his personal account and a corporate account under his control, said CBOT. These trades resulted in a profit of US $11,512.50 for Mr. Wei’s personal account and a corresponding loss in the corporate account. Mr. Wei agreed to pay a fine of US $25,000 to settle the charges and submitted to a 10-day suspension from all CME Group exchanges. 

• Proposed Bank Capital Treatment for Derivatives Will Discourage Clearing Argue CFTC Commissioners in Comment Letter to Prudential Regulators: Four Commodity Futures Trading Commission commissioners challenged an amended element of capital computations by banks proposed by three prudential regulators that the commissioners claimed would discourage bank clearing members from providing clearing services. 

According to CFTC Chairman J. Christopher Giancarlo and three CFTC commissioners – Rostin Behnam, Dan Berkovitz, and Brian Quintenz – the proposed amendment by the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation to the method of computing bank’s supplemental leverage ratio would not adequately give credit to the risk-reducing impact of a clearing firm receiving and holding a client’s initial margin against a client’s derivatives position. This proposed amended method – termed “SA-CCR” – would “maintain or increase the clearing members’ SLRs by more than 30 basis points on average, will continue to disincentivize clearing members from providing clearing services, and thereby limit access to clearing in contravention of G20 mandates and Dodd-Frank,” said the commissioners in a comment letter to the prudential regulators. The commissioners noted that offset is warranted as clearing members cannot use client margin for leverage for any proprietary purpose by law. Dawn Stump, the fifth CFTC commissioner, recused herself from joining the comment letter.

In 2017 the US Department of Treasury recommended that the bank leverage ratio calculations should exclude initial margin for centrally cleared derivatives. (Click here for details in the article “US Department of Treasury Recommends Modifications to Volcker and Bank Capital Rules, and Rationalization of Financial Regulation” in the June 18, 2017 edition of Bridging the Week.)

The SLR requires some of the largest US banks to set aside as much as 5 percent of their assets as a guard against losses. Currently, these assets include cash posted as margin by customers for their swaps and other derivatives trading activity through the banks’ futures commission merchant subsidiaries. 

• Hong Kong Regulator Sanctions Broker US $2 Million Equivalent for AML Violations Related to Third Party Suspicious Deposits: The Hong Kong Securities and Futures Commission fined Guosen Securities (HK) Brokerage Company the equivalent of approximately US $2 million (HK $15.2 million) for accepting 10,000 third-party deposits totaling HK $5 billion for more than 3,500 customers. SFC claimed that Guosen Securities did not have in place sufficient internal controls to adequately monitor for money laundering and terrorism financing and did not follow up on red flags regarding third-party deposits or report suspicious activities to the Joint Financial Intelligence Unit as required under HK law. Additionally, SFC noted that the firm did not have adequate policies and procedures to verify the identities of third parties or to determine the relationship between clients and third parties. Over 9,000 of the third party deposits accepted by Guosen were in cash, charged the SFC.

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