Bridging the Week: Examination Priorities, Disruptive Trading

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Bridging the Weeks by Gary DeWaal: December 23, 2019, to January 10, 2020, and January 13, 2020 (Examination Priorities; Slow Down, You Move Too Fast; Disruptive Trading)

by: Gary De Waal of Katten - Corporate and Financial Weekly Digest

Friday, February 7, 2020

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It was not part of the recently concluded Golden Globes ceremony, but last week both the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations and the Financial Industry Regulatory Authority issued their top inspection priorities for 2020. Separately, the Commodity Futures Trading Commission’s Division of Swap Dealer and Intermediary Oversight somewhat rolled back the immediate urgency for futures commission merchants and swap dealers to address all the recommendations of DSIO in its December 2019 Advisory regarding Chief Compliance Officer Annual Reports. As a result, the following matters are covered in this week’s edition of Bridging the Weeks:

Evaluating Fintech Applications and Information Security Among SEC’s Inspection Group’s and FINRA’s 2020 Examination Priorities
CFTC DSIO Says Recent CCO Annual Report Guidance Aspirational for 2020, More Relevant for 2021
Purported Wash Trades, Disruptive Trading and Speculative Position Limits Violations Targets of CME Group Exchanges’ Year-End Disciplinary Actions and more.

Article Version:

Briefly:

Evaluating Fintech Applications and Information Security Among SEC’s Inspection Group’s and FINRA’s 2020 Examination Priorities: Last week, both the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations and the Financial Industry Regulatory Authority issued their annual Examination Priorities. Each regulatory entity identified many common areas for their 2020 reviews, including sales practices, preparation for and compliance with new requirements under Regulation Best Interest; fintech applications, such as digital assets; and information security.
As in prior years, OCIE noted that it will prioritize the protection of retail investors in its reviews. It will seek to ensure that required disclosures are being made, particularly those related to fees and expenses and conflicts of interest. Additionally, after June 30, OCIE intends to evaluate both broker-dealers’ and registered investment advisors’ implementation of Regulation BI and use of Form CRS. (Click here for an overview of Regulation BI and Form CRS in the article “SEC Adopts New Regulation to Ensure Retail Customers’ Best Interest Takes Priority Over Broker-Dealer’s” in the June 9, 2019 edition of Bridging the Week.)

OCIE indicated it will also continue to identify and examine registrants who are involved with digital assets. Among specific areas of attention will be suitability, investment management and trading practices, protection of clients’ funds and assets, pricing and valuation; effectiveness of compliance programs, and controls and oversight of outside business activities. OCIE will also prioritize review of investment advisors that provide their clients automated investment tools and platforms commonly known as “robo-advisors.”

Additionally, OCIE proposed to continue to prioritize information security at registrants, paying close attention to the configuration of network storage devices, information security governance generally and retail trading information security. OCIE expressly will focus on registrants’ oversight of certain service providers and network solutions, including those providing cloud-based storage, among other topics.

As before, OCIE will review broker-dealers’ and investment companies’ anti-money laundering programs, including the monitoring and potential reporting of suspicious activities, and emphasize review of never–before or not recently examined investment advisors.

Similarly, FINRA indicated that, in its examinations of members, it would focus on sales practices and supervision, market integrity, financial management and firm operations. Among other things, FINRA intends to consider how firms comply with their obligations to help prevent market manipulation, report certain transactions and handle short sales. FINRA will seek to determine whether firms engaging in digital assets businesses have filed a continuing membership application with it, how fair and balanced relevant marketing materials are, whether firms imply that digital assets businesses being conducted through a non-SEC-registered affiliate are being overseen by a registered broker-dealer, and what controls and procedures a member has to support its digital assets transactions. FINRA will also examine the robustness of members’ policies and procedures to protect customer records and information and firms’ business continuity plans. Like OCIE, FINRA will review members’ implementation of Regulation BI and Form CRS after June 30, and evaluate their preparedness for the new requirements beforehand.

Compliance Weeds: The beginning of every year provides a natural opportunity for registrants to review their written policies and procedures to ensure they accurately reflect current requirements and practices and, if applicable, current personnel. It is easy, over time, for policies and procedures to become stale and persons referenced by name in such documents to no longer be with a registrant. Unfortunately, if something goes wrong, it will not be helpful to have written policies grounded on outdated regulatory requirements, practices that are inconsistent with written policies, or written policies that are so generic they are not correlated to actual practices. Ensuring that policies and procedures address hot button issues identified by regulators in summaries of examination priorities – such as the OCIE’s and FINRA’s 2020 examination priorities – is also advisable.
CFTC DSIO Says Recent CCO Annual Report Guidance Aspirational for 2020, More Relevant for 2021: The Commodity Futures Trading Commission’s Division of Swap Dealer and Intermediary Oversight advised futures commission merchants and swap dealers that guidance it issued on December 4, 2019, regarding chief compliance officers’ annual reports was more aspirational than mandatory for such registrants’ 2019 reports to be filed this year. Acknowledging the late issue of its guidance, DSIO said that while it expected CCOs to “take reasonable measures” to institute the guidance’s recommendations this year, it expects CCOs “to consider those recommendations more completely when preparing their 2020 annual reports” to be filed in 2021.
In its December 4 Advisory, DSIO principally made recommendations regarding those portions of the CCO annual reports dealing with (1) areas for improvement; (2) prospective changes or improvements to compliance programs; (3) financial, managerial, operational and staffing resources; (4) material noncompliance issues; and (5) material changes to compliance policies and procedures. Staff also included recommendations regarding the CCO’s annual report’s certification requirement and other matters. (Click here for background on DSIO’s December 4 CCO annual report guidance in the article “Based on Experience, CFTC Staff Makes Recommendations of Better Practices for FCMs’ and Swap Dealers’ Chief Compliance Officer Annual Compliance Reports” in the December 8, 2019 edition of Bridging the Week.)

Compliance Weeds: Talk about being between a rock and a hard place. When a regulator issues guidance but later says, “This year, solely do the best you can to implement the guidance’s recommendations,” what do you do? Likely, follow that instruction literally – do the best you can and don’t worry if you can’t institute all of the regulator’s proposals. However, make sure you have considered each of them and to the extent one or more specific proposals are not feasible because of insufficient time, it’s not a bad idea to document your analysis and make sure you retain that documentation.
Purported Wash Trades, Disruptive Trading and Speculative Position Limits Violations Targets of CME Group Exchanges’ Year-End Disciplinary Actions: At the end of 2019, two CME Group exchanges – the Chicago Mercantile Exchange and the Chicago Board of Trade – settled a number of disciplinary actions involving allegations of wash trading, disruptive trading and speculative positions limits violations.
In three related actions, involving Adrien Froidure, Charlotte Saint-Paul and Pierre Tomatis, CME alleged that each respondent engaged in indirect wash trades. According to CME, at various times in December 2017 and January 2018, in a coordinated fashion, Mr. Froidure bought or sold futures contracts opposite Ms. Saint-Paul who then sold or bought the same quantity of futures contracts at the same price opposite an account owned jointly by Mr. Froidure and Mr. Tomatis. Mr. Tomatis also used Mr. Froidure’s Tag 50 identification when entering orders on Globex. To resolve these disciplinary actions, Mr. Froidure and Mr. Tomatis each agreed to pay a fine of US $20,000 and be suspended from all CME Group exchanges’ access for three months, while Ms. Saint-Paul consented to a US $20,000 fine and a two-month suspension. The three respondents are all CME nonmembers.

Separately, Andrew Lombara agreed to pay a fine of US $60,000 to the Chicago Board of Trade and incur a 10-business-day all CME Group exchanges’ access ban for engaging in disruptive trading. According to CBOT, from August 31, 2015, to January 8, 2016, Mr. Lombara would place large orders in US Treasury Bond futures on one side of the market and smaller displayed iceberg orders on the other side of the market with the intent to have other traders transact opposite his smaller displayed orders. CBOT said that Mr. Lombara was successful in executing more of his smaller displayed orders than his larger orders utilizing his strategy. CBOT alleged that this strategy violated a CBOT rule that precludes entry or causing to be entered actionable or nonactionable messages with the intent to mislead other market participants. (Click here to access CBOT Rule 575B.) Additionally, Charles Mensh consented to pay a fine of US $30,000 and a 15-business-day all CME Group exchanges’ access ban for engaging in purported spoofing transactions from September 27 through October 4, 2018. CBOT alleged that Mr. Mensh layered large orders on one side of various futures markets and cancelled them after smaller resting orders on the other side of the relevant market were executed.

Finally, both Todd Delay and Grantham, Mayo, Van Otterloo & Co. LLC acquiesced to pay fines of US $15,000 and disgorge profits as a result of allegedly violating exchange speculative positions limits overnight or for one day. Both were nonmembers.

Compliance Weeds: It is important to remember that CME Group exchanges – similar to ICE Futures U.S. and CBOE Futures Exchange – prohibit four types of disruptive trading:
entering orders or causing orders to be entered with the intent to cancel or modify the order before execution to avoid execution. This type of activity is typically referred to as spoofing and was allegedly at issue in the conviction of Michael Coscia. (Click here for background in the article “Federal Appeals Court Upholds Conviction and Sentencing of First Person Criminally Charged for Spoofing Under Dodd-Frank Prohibition” in the August 7, 2017 edition of Between Bridges.);
entering or causing to be entered actionable or nonactionable messages with the intent to mislead other participants. This type of activity was purportedly at issue in Mr. Lombara’s disciplinary action;
entering or causing to be entered actionable or nonactionable messages with the intent to overload, delay or disrupt an exchange’s or other market participant’s systems; and
entering or causing to be entered actionable or non-actionable messages with the intent to disrupt or with reckless disregard for the orderly execution of transactions. This type of activity was allegedly at issue in CME’s disciplinary action against Saxo Bank for liquidating customers’ positions on an illiquid market. (Click here for background in 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.)
(Click here to access CME Rule 575, here for CFE Rule 620(b), and here for IFUS Rule 4.02(l).)

The prohibitions against disruptive trading under the Commodity Exchange Act are, on their face, less expansive. (Click here to access 7 U.S.C. § 6c(a)(5).)

More Briefly:
IFUS Authorizes More Types of Three-Party EFRPs and Proposes Modifications to Clearing Brokers’ Block Trades Obligations: ICE Futures U.S. amended its rule related to exchange for related position transactions as of January 1, 2020, to authorize a third party to facilitate as principal the cash or over-the-counter component of an EFRP on behalf of a customer. In such circumstances, the third party must act on behalf of a customer who is a party to the futures leg of the EFRP and the third party must pass through to the customer the related position. Ordinarily, an EFRP may involve only two parties – one party who buys the exchange-traded futures or options positions and sells the related position, and the other party who sells the exchange-traded futures or options position and buys the related position. IFUS's new rule amendment parallels a CME Group exchanges' rule. (Click here to access CME Rule 538.A.)
Separately, IFUS proposed to amend its block trade rule and associated guidance to relieve clearing members of their current obligation to exercise “due diligence” to ensure that a customer entering into a block trade is an eligible contract participant. (Click here for background on ECPs at 7 U.S.C. § 1a(18).) Instead, a clearing member would solely have to take “appropriate action” if it had actual or constructive knowledge that a relevant customer was not an ECP. Additionally, IFUS proposed to clarify that only when a customer has provided “express” consent, could a broker disclose to a potential block trade counterparty the customer’s identity. A broker could not rely on implied or negative consent, or a general disclosure. Also IFUS proposed to authorize brokers to communicate to a potential counterparty involved in the negotiation of a possible block trade that the negotiation has ended; however, a party receiving such information could not trade on or disclose the information to any other person prior to the block trade being publicly posted.
Private Litigants Allege That Companies Associated with Crypto Exchange and Related Stable Coin Manipulated Bitcoin As Well As CME and CFE Bitcoin Futures Contracts: Companies associated with Bitfinex and its associated stablecoin, tether, were named in a putative class action lawsuit, alleging that, from October 1, 2014 through the present, they manipulated bitcoin and futures contracts based on bitcoin traded on the Chicago Mercantile Exchange and the Cboe Futures Exchange (CFE). According to the plaintiffs, defendants effectuated their manipulation by issuing tether digital tokens that were not backed 100 percent by reserves to purchase bitcoin. The plaintiffs claimed that statistical analysis demonstrated that "[b]itcoin returns generally declined just before [tether] issuance dates and improved afterwards. This suggests that Defendants printed [tether] to manipulate and support the price of Bitcoin upwards."
Plaintiffs filed their lawsuit in a federal court in New York City.

During November 2019, two of the three current named plaintiffs – Eric Young and Adam Kurtz – filed the same essential lawsuit in a federal court in Washington State (click here to access the relevant complaint) then withdrew that lawsuit on January 7. David Crystal is a new plaintiff added to the latest action. At the time of the prior action, Bitfinex issued a statement denying plaintiffs' allegations, claiming that "Bitfinex and its affiliates have never used Tether tokens or issuances to manipulate the cryptocurrency market or token pricing. All Tether tokens are fully backed by reserves and are issued and traded on Bitfinex pursuant to market demand, and not for the purpose of controlling the pricing of crypto assets." (Click here to access Bitfinex's full statement.)

In April 2019, the Office of the Attorney General for the State of New York obtained an ex parte order from a New York State court prohibiting companies associated with the management of the cryptoasset exchange Bitfinex as well as the stablecoin tether from accessing, loaning or encumbering in any way US dollar reserves supporting tether digital coins. The NY AG had applied for such order without giving respondents notice or having an opportunity to object, claiming such emergency action was necessary because of the potential danger of respondents compromising tether’s supporting balances to help fund Bitfinex's operations. (Click here for background in the article "NY Attorney General Sues Stablecoin Issuer and Related Companies for Purportedly Misusing Tethered Fiat Currency Without Customer Disclosure" in the April 28, 2019 edition of Bridging the Week.)

In December 2019, the NY AG opposed efforts by respondents to have all legal proceedings against them by the AG dismissed. Defendants claimed such action was warranted because of improper service of court papers initiating the legal action; because the dispute does not emanate from activity in New York; and because tether is not covered by the reach of the relevant law – the Martin Act – because the stablecoin is neither a commodity nor a security. (Click here for background in the article "Bitfinex Entities and NYS AG Express Different Views Regarding Legitimacy of AG's Tether Investigation" in the December 15, 2019 edition of Bridging the Week.)

In other legal and regulatory developments involving cryptoassets:
Defendant Charged by SEC With Unlicensed Securities Offering in Connection With Proposed ICO at Least Temporarily Prevails in Challenge to Commission’s Subpoena of Bank Records: A federal court in New York City denied, without prejudice, a request by the Securities and Exchange Commission to compel Telegram Group Inc., and its wholly owned subsidiary, TON Issuer Inc. to produce subpoenaed bank records. Defendants had claimed that such production could violate foreign data privacy laws. On January 10, the SEC renewed its motion to compel defendants to produce the subpoenaed bank records, claiming that their claim of potential violation of foreign data privacy laws was too vague but, in any case "insufficient to rebut the presumption in favor of discovery that applies in federal courts even in the face of an assertion that foreign blocking statutes impede production." (Click here for a copy of the relevant SEC letter.)
In October 2019, the SEC sued the defendants and obtained a temporary restraining order, claiming that, beginning in January 2018, they engaged in an unregistered securities offering to fund the development of a proprietary blockchain – the Telegram Open Network – as well as their mobile messaging application, Telegram Messenger. Subsequently, defendants denied that their proposed issuance of “Gram” digital tokens would have been part of an illegal securities offering because, said the defendants, when issued, Grams would have constituted a virtual currency and/or a commodity and not a security under federal law. (Click here for background in the article "Messaging Service Company Denies SEC’s Claim That Sale and Issuance of Cryptocurrency Constitutes Unlawful Security Offering" in the November 17, 2019 edition of Bridging the Week.)
HK Affiliate of US Asset Manager Fined HK $3.5 Million for Dealing in Futures Contracts Without Required License: The Hong Kong Securities and Futures Commission fined FIL Investment Management (Hong Kong) Limited – part of Fidelity Investments – HK $3.5 million (approximately US $451,000) for dealing in futures contracts while unlicensed and for using an outdated checklist in connection with an application for a new fund. According to SFC, from August 2007 through July 2018, FIL engaged in approximately 6,700 trades for funds or accounts managed by affiliated companies where FIL had no discretion and for which FIL received compensation from its affiliates on a cost-plus basis. Additionally, charged SFC, FIL failed to disclose this breach to it until August 2018 after learning of it in June 2018. Finally, claimed SFC, “due to inadvertent human errors,” FIL used an incorrect template in an application for a new fund in March 2017, and thus failed to provide SFC certain required information. In determining its sanction, SFC considered that FIL’s actions were not intentional or deliberate, no client suffered financial loss, and the firm utilized an independent reviewer to assess its internal controls regarding its application process and took remedial measures to enhance its internal controls. SFC also acknowledged FIL’s cooperation.
SEC Charges Former CEO and Employee of Defunct Broker-Dealer of Aiding and Abetting Registrant’s Net Capital Violations: The Securities and Exchange Commission filed an enforcement action against Benjamin Mekawy and Alan Seidel for aiding and abetting minimum net capital violations of a broker-dealer that employed them – Seidel & Co., LLC – from October through November 2016. Mr. Seidel was the founder of the broker-dealer and, at the relevant time, a part-owner and the chief executive officer; Mr. Mekawy was an employee of the firm.
According to the SEC, during the relevant time, the firm had inadequate regulatory capital to meet SEC minimum requirements. However, to the firm’s third-party financial operations professional (FINOP), the SEC and the Financial Industry Regulatory Authority, Mr. Mekawy concealed a liability for back rent by falsely claiming it had been paid in full; Mr. Mekawy forged an account statement from the firm’s clearing broker to show a larger balance on deposit than actually existed; and Mr. Seidel falsely represented that a US $1 million deposit into one of the firm’s bank accounts represented a capital infusion when, in fact, it was solely loan proceeds, alleged the SEC.

The SEC seeks an injunction against futures violations and fines from each of the defendants. The SEC filed its enforcement action in a federal court in New York City.
FINRA and Multiple Exchanges Resolve Disciplinary Action Against Broker-Dealer for Alleged Reg MAR Violation for US $6.5 Million Fine: Credit Suisse Securities (USA) LLC agreed to pay a fine of US $6.5 million to the Financial Industry Regulatory Authority and multiple securities exchanges for purportedly not complying with the Securities and Exchange Commission’s Market Access Rule following its effective date on July 14, 2011, through July 2014. Among other things, claimed FINRA, Credit Suisse did not implement “effective” post-trade controls to monitor potential manipulative activity by three clients that generated over 50,000 alerts at FINRA during the relevant time. Among other things, charged FINRA, from July 2010 through October 2013, the firm allegedly did not have an automated system to detect potential spoofing and layering activity.
After the firm implemented an automated system through April 2014, it still failed to detect problematic activity by the three customers. Only after Credit Suisse made changes to its automated system in late April 2014 did it begin to detect the three customers’ problematic activity and terminate the three customers.

As part of its settlement, Credit Suisse also agreed to confirm certain remediation steps it has taken to enhance its surveillance and procedures designed to monitor for potentially manipulative trading.

Reg MAR – adopted by the Securities and Exchange Commission in 2010 – generally requires a broker or dealer with access to trading securities directly on an exchange or alternative trading system to have procedures and controls reasonably designed to limit their financial exposure as a result of such access and ensure compliance with all applicable regulatory requirements. (Click here to access Reg MAR, SEC Rule 15c3-5. Click here for helpful answers to frequently asked questions related to Reg MAR provided by the SEC’s Division of Trading and Markets.)
European Financial Regulator Announces 2020-22 Strategic Priorities: The European Securities and Markets Authority emphasized the importance of completing a single rulebook for EU financial markets and “supervisory convergence” to ensure consistent implementation of the same rules across the European Union as primary objectives in its Strategic Orientation 2020-22 published last week. ESMA also hopes to continue to promote the development of a large retail base to develop capital markets as an alternative to bank lending; to promote transparency by issuers and market participants regarding environmental, social and governance factors; and to study the role of digitalization and data in financial services. In its priorities, ESMA also noted its need “vis-à-vis third country [central counterparties]” to heighten its risk identification and financial stability assessments and to enhance its “pro-active co-operation with third country supervisors.”
NY DFS Warns of Potential Increased Cyberattacks From Iran: The New York Department of Financial Services issued a warning regarding the potential for “heightened risk of cyber attacks” from interests aligned with Iran following the recent US action against Qassem Soleimani. Although it identified no specific, credible reports of new cyber activities sponsored by Iran, DFS cautioned that “all regulated entities should be prepared to respond quickly to any suspected cyber incidents.” In the past, noted DFS, Iranian-aligned hackers have principally relied on “common hacking tactics” such as phishing, credential stuffing, password spraying and aiming at unpatched devices.

Video Version:

For further information:

CFTC DSIO Says Recent CCO Annual Report Guidance Aspirational for 2020, More Relevant for 2021:
https://www.cftc.gov/PressRoom/SpeechesTestimony/dsio120419advstatement010220?utm_source=govdelivery

Defendant Charged by SEC With Unlicensed Securities Offering in Connection With Proposed ICO at Least Temporarily Prevails in Challenge to Commission’s Subpoena of Bank Records:
/ckfinder/userfiles/files/Telegram%20-%20Order%20of%20Court%20SEC%20Subpoena.pdf

European Financial Regulator Announces 2020-22 Strategic Priorities:
https://www.esma.europa.eu/sites/default/files/library/esma22-106-1942_strategic_orientation_2020-22.pdf

Evaluating Fintech Applications and Information Security Among SEC’s Inspection Group’s and FINRA’s 2020 Examination Priorities: