Last week, the Securities and Exchange Commission overturned a decision of the Chicago Board Options Exchange in a disciplinary matter that had fined a broker-dealer and two principals US $1 million for not applying customer identification and margin requirements to traders of two omnibus customers. The SEC said CBOE misunderstood who the broker-dealer’s customers were. Separately, a trader was sanctioned over US $3 million by the New York Mercantile Exchange for trading on his employer’s confidential information to the detriment of his employer; while the Commodity Futures Trading Commission submitted papers in an enforcement action in a Chicago federal court arguing that the definition of spoofing under US futures law is clear. But is it? As a result, the following matters are covered in this week’s edition of Bridging the Week:

• SEC Overturns CBOE Determination That Individual Traders of Two Omnibus Accounts Were Customers Requiring Application of Customer Identification Rule (includes Compliance Weeds);

• Trader Sanctioned Over US $3 Million by CME Group for Trading on Confidential Employer Information; Both He and Wife Barred From Exchange Trading (includes Totally Irrelevant (But Is It?));

• DOJ and SEC Charge Former FDA Official With Obtaining Confidential Information to Fuel Insider Trading by Hedge Fund Managers (includes My View);

• CFTC Tells Court That Meaning of Spoofing Is Clear in Case Against Trader (includes My View);

• CFTC Seeks Public Comment on IFUS Proposed Block Trade Guidance Change;

• Private Fund Administrator Settles Charges With SEC for Not Acting on Red Flags of Possible Fraud; and more.

SEC Overturns CBOE Determination That Individual Traders of Two Omnibus Accounts Were Customers Requiring Application of Customer Identification Rule

The Securities and Exchange Commission set aside a determination by the Chicago Board Options Exchange, Inc. that Electronic Transaction Clearing, Inc., and two of its principals, Kevin Murphy and Harvey Cloyd, Jr., failed to apply its customer identification program to individuals trading on behalf of two omnibus accounts; failed to apply margin rules to the same traders; and failed to implement adequate surveillance tools for identifying suspicious activities of its customers.

CBOE previously filed charges in 2011 against the firm, the two principals, and the firm’s chief compliance officer and anti-money laundering compliance officer claiming that, between December 2009 and July 2010, the firm failed to comply with the CIP rule and margin requirements in connection with the multiple individual traders. (The CIP rule references a requirement under law and of the Financial Crimes Enforcement Network of the US Department of Treasury that broker-dealers, as well as certain other financial institutions, must obtain, verify and record certain information that identifies each person who opens an account; click here for more information related to requirements of broker-dealers.)

The BCC also found that the firm failed to have adequate surveillance tools in 2010 because for a portion of the year, it temporarily de-activated its electronic monitoring system for potential wash sales and other possible manipulative activity. The BCC identified other violations too (i.e., the failure to conduct an independent audit of its AML program in 2009 and the failure to timely close out one customer short sale in 2010) and imposed a US $1 million fine against ETC and the two principals, as well as other sanctions.

The firm and the two principals appealed the BCC’s decision to CBOE’s Board of Directors; the Board upheld the BCC’s decision. The applicants then appealed to the SEC.

In ruling against CBOE, the SEC said the CIP rule only required ETC “to verify the identity of the named account holder.” Because ETC’s named customers were the two omnibus brokers, it was only required to apply its CIP requirements to them. For this reason too, only the omnibus brokers, not their traders, were subject to CBOE’s margin rules.

Finally, the SEC noted that ETC temporarily deactivated its surveillance system for bona fide reasons – to make the monitoring tool web-based, as it was requiring “extensive computer resources to run,” and not operating efficiently. During the time it deactivated its automated monitoring system, ETC employed other measures to help prevent wash and manipulative trading. Moreover, once it reactivated its automated surveillance system, ETC reviewed all trades that occurred while the system was down, said the SEC. As a result, concluded the SEC, ETC’s wash sale surveillance was not “unreasonable” during the relevant time period.

The SEC remanded the entire action against the firm and the two principals back to CBOE for reconsideration as CBOE’s fine and sanctions were based on findings related to all its initial charges, including the ones the SEC set aside in its decision.

Compliance Weeds: The Financial Crimes Enforcement Network recently finalized rules requiring banks, broker-dealers, future commission merchants, introducing brokers and mutual funds (collectively, “covered firms”) to identify the beneficial owners of their legal entity customers. Such entities are currently required to know the identity of each of their legal entity customers under their CIP requirements, but not necessarily their beneficial owners. FinCEN also adopted rules making explicit the obligation of covered firms to understand the nature and purpose of their customer relationships in order to develop customer risk profiles; conduct ongoing monitoring for reporting suspicious transactions; and, on a risk basis, maintain and update customer information. Covered firms must comply with FinCEN’s new rules beginning May 11, 2018. (Click here for details of these new rules.)

Trader Sanctioned Over US $3 Million by CME Group for Trading on Confidential Employer Information; Both He and Wife Barred From Exchange Trading

A panel of the Business Conduct Committee of the New York Mercantile Exchange found that, from April 18, 2012, through December 10, 2012, Jon Ruggles, a nonmember and former trader for Delta Airlines, traded two accounts of his wife, Ivonne Ruggles, relying on confidential information of his employer in a manner that disadvantaged it.

According to the BCC, on 82 instances during this time period, Mr. Ruggles either initiated a new position opposite his employer’s account, offset an existing position opposite his employer’s account, or front-ran orders ultimately placed for his employer’s account. The BCC found that Mr. Ruggles “was not authorized at any time to execute trades between the employer’s account and the commodity trading accounts of his wife.”

The BCC concluded that, during the relevant period, Mr. Ruggles accumulated profits in excess of US $3.3 million as a result of his unauthorized trading.

As a penalty, the BCC imposed a fine of US $500,000 against Mr. Ruggles, ordered disgorgement in excess of $2.8 million, and imposed a permanent CME Group all-products trading prohibition. The BCC did not order disgorgement of the entire amount of his alleged illicit profits because it noted that CME Group exchanges did not have the requisite authority to impose such a sanction on a nonmember until August 20, 2012.

Ms. Ruggles failed to appear for an interview requested by NYMEX staff in connection with the trading of her husband. In response, the BCC imposed a permanent CME Group all-products trading ban on Ms. Ruggles too. (Click here to access an article in the June 16, 2014 edition of Fortune describing trading and other activities by Mr. Ruggles.)

Totally Irrelevant (But Is it?): I hate footnotes in legal articles. My view has always been that if the text is important, include it in the body of the article; if it’s not important, don’t include it at all. However, much legal writing uses footnotes interchangeably both as depositories of very important information and very irrelevant information, as well as information that simply is not well explained. To me this is very bad practice and mandates a careful perusal of all footnotes (no matter how tiny the font) to all legal articles to see if anything important is buried there. (Click here to access a wonderful parody of lawyers’ writing style, include their use of footnotes, in the article, “The Common Law Origins of the Infield Fly Rule” in a 1975 edition of the University of Pennsylvania Law Review.) Footnotes were not used in the NYMEX disciplinary notice related to Mr. Ruggles’s alleged wrongdoing, but buried in the “Penalty” section of the notice was an ominous reference to another potentially pending legal action again Mr. Ruggles – this one by the Commodity Futures Trading Commission. According to the BCC, “[t]he Panel found that if Ruggles reached a settlement with the CFTC that included disgorgement of profits or should he be required to disgorge profits pursuant to a Court order, a dollar-for-dollar credit for the amount that Ruggles pays to the CFTC in disgorgement shall be credited against the disgorgement amount ordered by the Panel.” Foreboding? Stay tuned!

DOJ and SEC Charge Former FDA Official With Obtaining Confidential Information to Fuel Insider Trading by Hedge Fund Managers

The US Department of Justice and the Securities and Exchange Commission filed criminal and civil charges, respectively, against a former government official who obtained confidential information from his former agency, and then provided it to a hedge fund manager for trading.

According to the SEC, Sanjay Valvani  a hedge fund manager, realized US $32 million in illicit profits after receiving information about the likely approval by the Federal Drug Administration of a new generic drug and trading upon it. He received this information, charged the SEC in a civil complaint filed in federal court in New York, from Gordon Johnston, a former senior FDA officer, whom he had hired as a consultant. Mr. Johnston obtained this information through a former colleague at the FDA, said the SEC. In response, the SEC alleged that, in addition to trading on the information himself, Mr. Valvani shared this information with another former hedge fund manager, Stefan Lumiere, who likewise traded on the insider tips.

Mr. Johnston has pleaded guilty and admitted to his conduct in the DOJ criminal action.

The DOJ and SEC also filed criminal and civil charges against Mr. Lumiere and Christopher Plaford, another former hedge fund manager, for overstating the value of credit securities in funds they managed.

These individuals accomplished this, charged the DOJ and SEC, by instructing certain “friendly” broker-dealers of the specific prices they wanted for illiquid securities held by the funds and having the brokers send the prices back to them to be used as benchmarks for the funds’ valuations. The DOJ and SEC also charged that, on occasion, Mr. Plaford would purchase securities at higher than market prices (i.e., so-called “painting the tape”) to inflate the value of the securities and the value of the funds’ portfolio that included the securities.

Mr. Plaford has pleaded guilty to his criminal charges and admitted his role in the process.

In another matter, Rohit Bansal, the former Goldman Sachs & Co. and Federal Reserve Bank of New York employee, who illicitly obtained confidential information from the Fed while employed by GSCO for use by GSCO, agreed with the Financial Industry Regulatory Authority to be permanently barred from associating with any FINRA member. Mr. Bansal previously pleaded guilty to criminal charges related to this matter. (Click here for details.)

My View: It is precisely because of incidents like those involving Mr. Johnston and Mr. Bansal that industry representatives are so concerned about the proposal of the Commodity Futures Trading Commission in Regulation Automated Trading to require the proprietary source code of algorithmic traders to be made readily available to its staff and employees of the Department of Justice. Although regulators strive hard to prevent improprieties by their employees, they cannot prevent such incidents. Algorithmic traders potentially covered by Reg AT are very concerned that source code obtained by government regulators through a too low standard could make its way to competitors. Inadvertent leaks because of cybersecurity breaches are also a worry. This is why any provision adopted by the CFTC related to its or the DOJ’s ability to access source code must include sufficient protections against inadvertent leaks and disclosures.

Briefly:

• CFTC Tells Court That Meaning of Spoofing Is Clear in Case Against Trader: The Commodity Futures Trading Commission filed papers in its lawsuit against a proprietary trading firm and its principal, claiming that the federal law prohibition against spoofing is not unconstitutionally vague. The defendants in that action previously made a motion to the federal court in Chicago hearing the CFTC’s lawsuit that charges against them should be dismissed because, among other reasons, the definition of spoofing under law does not provide adequate notice regarding the prohibited conduct. (Click here for details; under applicable law, “[i[t shall be unlawful for any person to engage in any trading, practice, or conduct on or subject to the rules of a registered entity 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).) The CFTC claimed that “the spoofing provision [of the relevant law] is clear, and Defendants’ conduct … falls clearly within that language.” In this matter, the CFTC claimed that defendants placed orders on one side of the market with the intent to cancel them as evidenced by “(1) their pattern of cancelling those orders in less than a second and simultaneously flipping to the other side of the market to execute against market participants tricked by the spoof orders; (2) the difference between the fill and cancellation rates for the spoof orders, versus the flip orders, and (3) the placement of the spoof orders to avoid getting filled.” The defendants previously argued in support of their motion to dismiss that the CFTC has never provided official notice of what activity might qualify as spoofing or be of “the character of or commonly known to the trade as ‘spoofing.’” Defendants argued that “[t] he CFTC has had five years to try to rectify the vagueness of the Spoofing Statute by issuing a rule or regulation to prohibit trading practices that may constitute spoofing, but it has failed to do so.” As a result, said defendants, the relevant federal statute is void for vagueness.

My View: Although the relevant provision of law defines spoofing very precisely in a parenthetical phrase as “bidding or offering with the intent to cancel the bid or offer before execution,” defining an offense – if the definition is wrong or universally regarded as unclear – does not provide the type of fair notice that is necessary to make a law constitutionally valid. When the Financial Industry Regulatory Authority recently issued report cards to member firms to help them detect potential spoofing and layering activity, for example, it defined spoofing as “entering orders to entice other participants to join on the same side of the market at a price at which they would not ordinarily trade, and then trading against the other market participants’ orders.” FINRA’s definition does not require intent to cancel the bid or offer before execution; however it requires order placement on both sides of a market. (Click here for background on FINRA’s new spoofing report cards.) Although the CFTC may believe that everyone knows what spoofing is, the relevant statute is badly drafted and the parenthetical language that supposedly defines spoofing embraces both legitimate and potentially problematic conduct. Indeed, the CFTC acknowledged in its court papers last week that this was the industry’s position “under a literal reading of the spoofing provision.” However, argued the CFTC in its papers, “[t]he Complaint [in this matter] had nothing to do with these industry concerns.” It seems disingenuous for the CFTC to concede the controversy but claim it is irrelevant. If a law is too sweeping in scope, though it may be worded precisely, it does not provide adequate notice of what is allowed or prohibited. 

• CFTC Seeks Public Comment on IFUS Proposed Block Trade Guidance Change: The Commodity Futures Trading Commission delayed roll-out of a proposed amendment by ICE Futures U.S. to its block trade guidance that would permit the principal parties to a block trade to engage in pre- or anticipatory hedging of the position they believe in “good faith” will result from the “consummation” of a block trade. This ability would not exist for “an intermediary that takes the opposite side of its own Customer order” under IFUS’s proposal. The CFTC requested a delay in IFUS’s roll-out, which had been scheduled to become effective last week, because IFUS’s “submission presents novel or complex issues that require additional time to analyze.” The CFTC will accept public comment on IFUS’s proposal through July 14. IFUS’s proposal will now be effective on September 14 unless the CFTC objects. (Click here for additional information on IFUS’s proposal.)

• Private Fund Administrator Settles Charges With SEC for Not Acting on Red Flags of Possible Fraud: Apex Fund Services agreed to settle two enforcement actions by the Securities and Exchange Commission alleging that it ignored red flags and enabled fraudulent conduct by investment advisers and private funds they managed. Apex is a fund administration company located in New Jersey. In one action, the SEC charged that Apex enabled Clearpath Wealth Management, LLC, an investment adviser, and its president, Patrick Churchville, to engage in allegedly fraudulent conduct; Clearpath and Mr. Churchville are currently respondents in a separate SEC action in federal court in Rhode Island. According to the SEC, Clearpath and Churchville managed four private funds that engaged Apex in December 2011. Subsequently, claimed the SEC, Apex “ignored or missed red flags including undisclosed brokerage and bank accounts, related party transactions, inter-series and inter-fund transfers in violation of fund offering documents, and undisclosed margin or credit agreements.” As a result, Apex did not correct previously issued (but erroneous) accounting reports and capital statements that were used by Clearpath to communicate with investors and were provided to the fund’s independent auditor. In addition, the SEC separately charged Apex in connection with its accounting and administrative services to EquityStar Capital Management, LLC, an investment adviser, and its managing member, Steven Zoernack. Among other things, EquityStar and Mr. Zoernack made undisclosed and impermissible withdrawals of more than US $1 million from funds they managed, said the SEC. According to the SEC, from May 2012 through June 2014, Apex accounted for these withdrawals as receivables without any evidence that EquityStar or Mr. Zoernack would repay the amounts withdrawn. Apex provided financial statements to investors of the funds that did not identify or discuss the magnitude of the withdrawals. In both cases, the SEC charged that Apex’s conduct “was a cause” of the investment advisers and principal’s wrongful conduct. Apex agreed to pay fines and disgorgement totaling US $352,000 and to retain an independent consultant to resolve the SEC’s charges.

And more briefly:

• MiFID II and MiFIR Formally Delayed One Year: The European Council of the European Union formally delayed the application date of the Markets in Financial Instruments Directive II and the Markets in Financial Instruments Regulation to January 3, 2018. In addition, the date by which member states must adopt their own version of MiFID II through national legislation was delayed to July 3, 2017. These delays were previously agreed with the European Parliament on May 2, 2016. MiFID II and MiFIR are comprehensive measures that will greatly increase regulation of European financial markets by, among other things, (1) requiring the trading of certain financial and commodity instruments on regulated venues “whenever appropriate;” (2) increasing obligations on certain algorithmic traders; and (3) obligating speculative traders to limit the size of their net position in commodity derivatives.

• IEX Approved as a National Securities Exchange: The Investors’ Exchange LLC’s application to register as a national securities exchange was granted by the Securities and Exchange Commission last Friday. In conjunction with this approval, SEC staff issued guidance that an automated quotation system like IEX would satisfy the SEC’s requirement that it provide an immediate response to an immediate or cancel order if it implements “an intentional access delay that is de minimis.” The SEC suggested that a “one millisecond intentional access delay is well within the current geographic and technological latencies already experienced by market participants when routing orders between trading centers.” According to IEX, its automated system will incorporate a slight delay aimed to ensure that higher-speed traders cannot front-run orders of slower investors.

• Cleared Swaps Recordkeeping and Reporting Requirements Amended by CFTC: The Commodity Futures Trading Commission adopted a final rule related to the reporting of cleared swaps. Because cleared swaps entail both an original swap and an equal and opposite swap by a clearinghouse, the final rule allocates responsibilities for data reporting related to the two swaps among swap data repositories, clearinghouses, exchanges, swap dealers and major swap participants.

• CME Group Amends Approval Process for Subordinated Loans to Clearing Members: CME Group adopted new procedures for clearing members to process new subordinated loan agreements, loan amendments, revolving loan drawdowns, prepayment requests and lender assignments. Beginning July 1, all processing requests must be submitted using the WinJammer Online Filing System. A subordinated loan is a special type of financing subject to very restrictive conditions that the Securities and Exchange Commission and the Commodity Futures Trading Commission will permit certain registrants to use to help meet their net capital requirement. (Click here for a general discussion of subordinated loan agreements by the Financial Industry Regulatory Authority.)

• SEC Inspector General Criticizes Agency’s Sensitive Information Security: The Office of the Inspector General of the Securities and Exchange Commission issued a report criticizing handling of information security. Among other things, the OIG said that the SEC’s Office of Information Technology did not “effectively” monitor the risks of system authorizations. According to the OIG, “SEC systems continued to operate without current authorizations; user accounts were not always deactivated in accordance with policy; [and] continuous monitoring review procedures were developed, but not consistently implemented.”

• CME Group Authorized to Provide Clearing Services in the EU: Last week, the European Securities and Markets Authority formally recognized the Chicago Mercantile Exchange, Inc. as a third-country clearinghouse (CCPs) permitted to offer clearing services within the European Union. This permits European market participants to satisfy their clearing obligation by clearing mandated products on the CME, as well as through other recognized third-country clearinghouses or on EU-based authorized CCPs.

• IFUS Sanctions FCM for LTR Violations and IB for Block-Trading Handling Breakdowns: Wedbush Securities Inc., a futures commission merchant, agreed to pay a fine of US $20,000 to ICE Futures U.S. for allegedly not reporting large trader positions on multiple occasions from January through April 2015 and from September to October 2015. IFUS also was charged with possibly not having adequate procedures to discover LTR errors. Separately, Bosworth Brokers LLC, an introducing broker, agreed to pay a fine of US $25,000 for multiple instances of purported recordkeeping violations. IFUS charged that the broker may have failed to prepare required records of block trades; misreported the correct execution time of block trades; submitted reports of block trades beyond the required time; and not had procedures to ensure correct block trade details were reported to the exchange. IFUS also alleged that the broker should be sanctioned for its “late production of documents, books or records requested by Compliance staff.”

• ICE Futures Europe Amends Guidance on Block and Asset Allocation Trades: ICE Futures Europe amended its guidance related to block trades to include asset allocation transactions. Asset allocation transactions enable members to arrange transactions involving a specified combination of two fixed income contracts on a bilateral basis in an appropriate ratio (e.g., hedge ratio). Among other matters, to qualify, the sum of the legs of the transaction must meet the lower of the applicable minimum outright block trade threshold of the contracts being traded. Reporting requirements for block trades also apply.

• Canadian Regulator AMF to Review Financial Innovations in the Financial Sector: The Autorité des marchés financiers of Quebec announced the creation of a fintech working group to analyze technological innovations in the financial sector. The goal of this working group will be to “analyze and make recommendations about the ability of the current regulatory framework to support changes in commercial practices, business models, and financial sector technologies while ensuring a solid balance between consumer protection and market efficiency.” AMF is yet another regulator that has begun studying technological innovations, mostly involving distributed ledger technology. A few weeks ago, the European Securities and Markets Authority published a discussion paper to solicit comments on DLT – a more generic term for what is sometimes referred to as the “Blockchain.”