The Commodity Futures Trading Commission sued a large precious metals dealer catering to retail clients for engaging in illegal precious metals transactions and fraud. However, the firm claimed its activities were outside the CFTC’s jurisdiction. Separately, a US federal court ruled that the Securities and Exchange Commission could charge that spoofing-type conduct constituted market manipulation, while seven regulators in China banned new initial digital coin offerings. As a result, the following matters are covered in this week’s edition of Bridging the Weeks:

• Retail Metals Dealer and Principals Sued by CFTC for Illegal Transactions and Fraud (includes Legal Weeds);

• Federal Court Rules Layering Can Be Market Manipulation (includes Legal Weeds);

• Two Firms Settle With CME Group Exchanges for Not Supervising Employees Who Allegedly Engaged in Disruptive Trading Practices (includes Compliance Weeds);

• China Bans ICOs While HK SFC Joins Regulator Procession Warning Digital Tokens in ICOs May Be Securities (includes Legal Weeds);

• Bank and Broker-Dealer Affiliates Settle SEC Charges of Secret Mark-Ups and Not Disclosing Material Information About Trading Platform; and more.

Please take some time today to reflect upon the victims and families of the victims of 9/11.

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Retail Metals Dealer and Principals Sued by CFTC for Illegal Transactions and Fraud: Monex Deposit Company and two affiliated companies (collectively, “Monex”), and Louis Cabrini and Michael Cabrini, the firms’ principals, were charged in a civil complaint by the Commodity Futures Trading Commission with fraud and engaging in illegal precious metals transactions with retail clients. The complaint was filed in a federal court in Illinois.

According to the CFTC’s complaint, from July 16, 2011, through March 31, 2017, Monex offered leveraged precious metals trading to retail clients through its “Atlas” trading program. Through this program, retail clients purchased and sold precious metals; paid only a portion of the purchase price; and either borrowed the difference (for purchases) or borrowed the metal (for sales). Clients were subject to margin calls if the value of their account equity declined below a certain level (determined in Monex’s discretion), and forced liquidation, if the value of their account value fell to 7 percent.

The CFTC charged that these leveraged purchase and sales to retail clients constituted prohibited off-exchange futures contracts, and that Monex operated as a futures commission merchant without required registration in facilitating these transactions. 

In addition, the CFTC claimed that Monex made material misrepresentations in their claims regarding the Atlas program and that the misstatements constituted fraud. The CFTC alleged that 12,000 leveraged Atlas accounts sustained more than $290 million in losses during the relevant period. Additionally, the CFTC charged that Atlas customers never took possession or control of precious metals they purchased.

In a "Response of Monex to CFTC Law Suit", Monex "vehemently" denied the CFTC’s allegations, claiming that its physical precious metals transactions were exempt from CFTC jurisdiction and that its disclosures to customers “satisfy all regulatory requirements.” The CFTC seeks a permanent injunction, cease-and-desist order, rescission of all contracts and agreements with customers, restoration of all initial payments by customers to Monex and a civil monetary penalty against all defendants.

Prior to filing this lawsuit, the CFTC prevailed in legal actions to compel Monex to produce various documents in response to an investigative subpoena, and later to authorize the Commission to use all documents it received from Monex in any enforcement proceeding against the company. Monex had argued that the CFTC lacked authority to investigate it because the firm was outside the CFTC’s jurisdiction. The federal appeals court in Illinois rejected this argument, claiming the issue of jurisdiction was factual and that the CFTC had authority to require the productions of documents that were relevant to any potential enforcement action.

Legal Weeds: Under relevant law, all contracts for commodities for future delivery when offered to retail clients on a leveraged or margined basis, or financed “by the offeror, the counterparty, or a person acting in concert with the offeror or counterparty on a similar basis,” must be executed on or subject to the rules of a designated contract market.

Contracts for commodities that result in actual delivery within 28 days or create an enforceable obligation to deliver between a seller and buyer that have the ability to deliver and accept delivery, respectively, in connection with their line of business, are exempt from this requirement.

Given the arguments raised by Monex during the CFTC’s subpoena enforcement action and its written response, it would not be surprising if the defendants make a motion to dismiss at least some of the charges in the Commission’s lawsuit, arguing that its Atlas program transactions are within this exemption and outside the CFTC’s jurisdiction. Suggesting this, Monex said that it “makes delivery of precious metals to every customer on every sale, including financed transactions where the precious metals are held in an independent depository in the customer’s name” in its written response to the Commission’s complaint.

The CFTC’s anti-manipulation authority adopted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act prohibits manipulation or the dissemination of false information in connection with transactions involving commodities in interstate commerce – not just with futures or swaps.

Federal Court Rules Layering Can Be Market Manipulation: The US District Court in New York hearing the enforcement action by the Securities and Exchange Commission against Lek Securities and Samuel Lek, its 70 percent owner and chief executive officer (collectively, the “LEK Defendants”), denied the defendants’ motion to dismiss, ruling that layering and cross-market manipulation as alleged by the SEC in its complaint can constitute market manipulation in violation of federal securities laws.

The SEC sued the LEK Defendants on March 10, 2017, for facilitating manipulative trading by Avalon FA Ltd., a non-US entity, and its two control persons, Nathan Fayyer and Serge Pustelnik

In its complaint against the LEK Defendants, the SEC alleged that on “hundreds of thousands of instances” from December 2010 through at least September 2016, Avalon placed false orders in various stocks on one side of a marketplace to drive a stock’s price up or down. It did this, said the SEC, “to trick and induce other market participants to execute against Avalon’s bona fide orders (i.e., orders  Avalon intended to execute) for the same stock on the opposite side of the market.” After executing its legitimate orders at more favorable prices, Avalon cancelled its other-side-of-the-market layering or spoofing orders, the SEC claimed. In addition, charged the SEC, from April 2012 through December 2015, Avalon bought and sold stocks at losses in order to influence the market for corresponding options on the stocks. Avalon then made a profit by trading these options at “artificial prices.” The SEC charged that the LEK Defendants facilitated Avalon’s allegedly improper conduct.

In their motion to dismiss, the LEK Defendants argued that all of Avalon’s layering activity involved “live, real and actionable” orders that were subject to market risk, and thus could not create a false impression of supply and demand. They also claimed that Avalon’s cross-market activity also involved “real buyers” and that its activity was to hedge stock trades – a legitimate activity. The court rejected these arguments noting that, in a motion to dismiss, factual assertions are inappropriate. In addition, the court said that providing brokerage services to a market manipulator if done with requisite knowledge could be deemed to assist the manipulator in violation of federal securities laws.

(Click here for background on the SEC’s enforcement action against the LEK Defendants in the article “US Broker-Dealer, Its CEO and a Non-US Client Sued by SEC for Layering and Other Manipulative Schemes” in the March 12, 2017 edition of Bridging the Week.)

Legal Weeds: As the SEC’s action against the LEK Defendants and the Commodity Futures Trading Commission’s September 2016 enforcement action against Advantage Futures LLC and two of its principals demonstrates, neither the SEC nor the CFTC appear reluctant to bring an enforcement action against a broker if the broker fails to take what the regulators consider to be responsible appropriate action in the face of well-supported allegations of wrongdoing by a customer.

In response to the CFTC’s enforcement action, Advantage, Joseph Guinan, its majority owner and chief executive officer, and William Steele, who until May 2016 was Advantage’s chief risk officer, settled charges related to the firm’s handling of the trading account of one customer in response to three exchanges’ warnings regarding the customer’s possibly illicit trading conduct.

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 thought 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 Exchange 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. (Click here for details of this enforcement action in the article “FCM, CEO and CRO Sued by CFTC for Failure to Supervise and Risk-Related Offenses” in the September 25, 2016 edition of Bridging the Week.)

Registrants should consider developing databases that permit them to log all regulatory inquiries and other extraordinary matters regarding their customers so they can more systematically evaluate potential red flags regarding customers’ conduct.

Two Firms Settle With CME Group Exchanges for Not Supervising Employees Who Allegedly Engaged in Disruptive Trading Practices: Jaypee Singapore PTE LTD and Skeet Commodities DMCC both agreed to settle disciplinary actions brought by CME Group exchanges that they failed to supervise employees who engaged in disruptive trading practices in violation of the exchanges’ rules.

Two employees of Jaypee – Deepak Gautam and Satya Sharma – simultaneously settled charges that they engaged in spoofing-type conduct in connection with their trading of silver and natural gas futures contracts from December 2015 through April 2016. Jaypee was charged with failing to provide its traders with guidance regarding the exchanges’ rules and regulations generally, and disruptive trading in particular, and not supervising its traders’ trading activities to ensure their compliance with the exchanges’ rules. To resolve these matters, Jaypee agreed to pay the Commodity Exchange, Inc and the New York Mercantile Exchange combined US $55,000, while Mr. Gautam consented to pay a US $7,000 fine and serve a three-month suspension from all CME Group trading and Mr. Sharma agreed to pay a US $5,000 fine and serve a six-month trading suspension.

Skeet Commodities was separately charged with failing to supervise in connection with the alleged disruptive trading by one of its employees by also not providing any relevant training to its employees, as well as “by not being familiar with Exchange Rules” generally. Skeet agreed to pay a penalty of US $30,000 to resolve this matter.

Unrelatedly, Bertram Consultants Limited consented to a US $50,000 fine to settle a Chicago Mercantile Exchange disciplinary action alleging that, from March 2015 to June 2015, it engaged in disruptive trading practices when it waited until several minutes before the termination of trading on the contract’s last day of trading to place a single market on close liquidating order for almost 400 June 2015 NASDAQ 100 futures contract. This occurred, said CME, even after the firm received ongoing notifications and reminders about the planned delisting of the contract after the last trading day. According to CME, “[t]he execution of the order resulted in price and volume aberrations.”

Finally, Bueno Café Comercio Exportacao resolved a disciplinary action brought by ICE Futures U.S. that claimed it may have engaged in wash sales to move positions between accounts under common control. The firm agreed to pay a fine of US $7,5000 to resolve this charge.

Compliance Weeds: CME Group has made it clear through multiple disciplinary actions that firms that fail to supervise employees who engage in disruptive trading activities (such as spoofing) risk sanctions.

In addition to the disciplinary actions against Jaypee and Skeet, Focus and Vision General LLC resolved a disciplinary action brought by the Commodity Exchange, Inc. earlier this year related to the alleged spoofing-type activities of one employee by agreeing to pay a fine of US $30,000.

However, CME Group has also indicated that, despite its capability to file charges against an employer saying that it is strictly liable for the wrongful acts of its employees and agents, it may not to seek to levy a penalty where the employer has engaged in meaningful supervision of its employees – even where the employees may also have engaged in disruptive trading practices. (Click here for background in the article “Recent CME Group Disciplinary Action Suggests Liability May Not Automatically Mean Fines” in the October 23, 2016 edition of Bridging the Week.)

Keep in mind that, under CME Group Rules, an agent for purposes of its strict liability rule includes an automated trading system. (Click here for background in the article “CME Group Settles With Trading Firm for Spoofing-Type Offenses, Holding It Strictly Liable for Acts of Agents; Orders Disgorgement of Profits” in the October 9, 2016 edition of Bridging the Week.)

China Bans ICOs While HK SFC Joins Regulator Procession Warning Digital Tokens in ICOs May Be Securities: Seven government regulators in China banned the use of initial digital coin offerings as a fundraising device (i.e., where startups distribute digital tokens to investors who make financial contributions using cryptocurrencies). According to the regulators, ICOs “are considered illegal and disruptive to economic and financial stability.” Moreover, organizations and individuals who have previously raised funds through ICOs must refund such funds “to protect investor rights.” Additionally, all China-based financial institutions and non-banking payment institutions are prohibited going forward from providing services to support any ICO, and China-based exchange platforms appear prohibited from providing exchange services between tokens issued as part of ICOs and fiat currencies as well buying or selling generally ICO-issued tokens and cryptocurrencies. Among the government regulators issuing this prohibition are the People’s Bank of China, the China Banking Regulatory Commission and the China Securities Regulatory Commission.

Separately, the Securities and Futures Commission of Hong Kong issued a notice stating that digital tokens offered or sold as part of ICOs may constitute securities and be subject to HK securities laws. According to SFC, under HK law, digital tokens issued as part of an ICO to represent equity or ownership interests may be “shares”; digital tokens issued to acknowledge or create a debt or liability may be “debentures”; and token proceeds used to invest in projects to enable token holders to share in the return on the project may render such tokens as interests in a “collective investment scheme.” Under HK law, said SFC, shares, debentures and collective investment schemes are all regarded as securities and subject to regulation.

The Financial Industry Regulatory Authority in the United States also issued an alert to investors related to ICOs within the past two weeks.

Legal Weeds: A chilling breeze is blowing internationally regarding ICOs.

On July 25, the US Securities and Exchange Commission published a Report of Investigation that concluded that digital tokens issued by an entity for the purpose of raising funds for projects – even if using distributed ledger or blockchain technology – may be securities under federal law. If so, such securities must be registered with the Commission or eligible for an exemption from registration requirements. Moreover, the SEC concluded that any person offering trading facilities like an exchange for digital tokens that are securities must be registered as a national securities exchange or be exempt from such registration requirement.

Shortly afterwards, the Canadian Securities Administrators also published guidance regarding how securities and derivatives laws in Canada might be impacted by ICOs and the sales of investment funds consisting of digital tokens.

The latest regulatory notices in China and Hong Kong, coupled with these prior advisories, likely point to the need to structure any new digital token issuance for projects as a bilateral contract for specific rights related to a project, as opposed to an investment in the project to profit mostly through the efforts of others.

Bank and Broker-Dealer Affiliates Settle SEC Charges of Secret Mark-Ups and Not Disclosing Material Information About Trading Platform: State Street Bank and Trust Company and two affiliated entities (collectively, “State Street”) settled charges with the Securities and Exchange Commission that, from February 2010 through 2011, they engaged in fraud in connection with transition services provided to six institutional customers. Separately, State Street Bank also settled SEC allegations that it failed to advise other users of its “GovEx” government securities trading platform that it provided one user “Last Look” functionality in order to reject matches to submitted quotes from September 2009 through July 2015.

State Street agreed to pay a fine of US $32.2 million to resolve the SEC’s charges regarding transition services, as well as to commit to certain undertakings, while State Street Bank consented to remit a penalty of US $3 million to resolve the SEC’s allegations regarding Last Look.

In connection with State Street’s provision of transition services, the SEC claimed the entities defrauded customers by charging them nondisclosed and unauthorized mark-ups and commissions in addition to fees, mark-ups and commissions the customers had agreed to pay. (Some financial institutions, like State Street, offer transition services to institutional clients who are changing fund managers or investment managers in order to minimize their potential costs when there is likely to be a large cost associated with a large number of transactions.)

Regarding Last Look, the Commission claimed that State Street Bank marketed its system as “fair and transparent” and provided its GovEx subscribers with a description of the system’s order handling system, without disclosing the development of the Last Look capability. Moreover, on at least two occasions, said the SEC, the firm affirmatively misrepresented that there was no Last Look capability on GovEx.

In January 2017, State Street Corporation agreed to enter into a deferred prosecution agreement and pay a US $32.3 million penalty as a result of charges by the US Department of Justice also related to the firm’s handling of transition services.

More briefly:

Operator of Fund Established to Purchase Oil and Gas Interests Settles CFTC Allegation It Acted as CPO Without Registration: W Resources, LLC, which from October 2013 to the present operated at least three private investment funds to purchase oil and gas interests, was charged by the Commodity Futures Trading Commission with acting as a commodity pool operator without required registration. This was because the funds hedged their financial exposure related to future oil production volume by trading crude oil options on the New York Mercantile Exchange. Under US law it is prohibited to act as a CPO without registration, subject to certain exemptions. To resolve this matter, W Resources agreed to pay a fine of US $150,000.

FCM Resolves CFTC Charges of Failing to Keep and Promptly Produce Records of EFPs for $200,000 Penalty: Ikon Global Markets, Inc., settled charges brought by the Commodity Futures Trading Commission that, from approximately February 9, 2012, through the present, the firm failed to keep and promptly produce as per the CFTC’s subpoena required records related to exchange for physical trades entered on NASDAQ OMX Futures Exchange, Inc. (“NFX”). According to the CFTC, Ikon, formerly registered as a futures commission merchant, executed “thousands” of EFPs from February 9 through September 12, 2012, involving gold and the cash-settled spot futures contract listed on NFX. Under CFTC rule, FCMs are required to “keep full, complete and systematic records… of all transactions related to its business of dealing in commodity interests and related cash or forward transactions.”The firm agreed to pay a fine US $200,000 to resolve the CFTC’s complaint. Ikon withdrew as a member of the National Futures Association in January 2013, and subsequently agreed never to reapply as an NFA member, to resolve NFA charges that it failed to cooperate in connection with a 2012 NFA audit.

NFA Proposes to Eliminate Form 3R and Revise Series 3 Exam Requirement for Persons Acting as Principals: The National Futures Association proposed a number of rule changes in connection with the overhaul of its online individual registration system. Among these changes is the elimination of the current authorization for principals of registrants not acting as associated persons who have taken and passed a proficiency examination (i.e., Series 3 or 30) not to have to retake the examination if they become reassociated with a registrant within two years of ceasing to be a principal. Also, the Series 3-R Form used to reflect changes to individuals’ Form 8-R information will be eliminated.

LME Proposes Path Forward: Following comments received in response to its Discussion Paper on Market Structure on April 24, The London Metal Exchange issued a “Strategic Pathway” articulating its proposed way forward “to evolve the market for the benefit of all stakeholders.” Among other things, LME stated it should take steps to enhance its electronic third Wednesday liquidity while maintaining its daily date structure. However, it will not propose financial incentives to encourage trading in a particular manner. Likewise, as an accommodation to physical hedgers, LME will not propose daily mark to market collection and payment of losses and gains as is common on other exchanges. However, LME will work with its members to accommodate such a system should it be required “as a result of exogenous pressures.” LME does not commit to implement any of its proposed recommendations.