The Commodity Futures Trading Commission recently settled allegations that Powerline Petroleum, a registered introducing broker (IB), failed to disclose its role as a counterparty to block-trades, assessing sanctions of $875,000. Separately, Powerline agreed to pay a fine of $225,000 to resolve similar allegations by a disciplinary committee of the New York Mercantile Exchange, as well as claims that it pre-hedged block trades contrary to the exchange’s requirements.  Notably, in a strongly worded dissenting statement to the CFTC settlement, Commissioner Summer K. Mersinger objected to certain aspects of the settlement order as “inconsistent with the Commission’s prior treatment of similar cases and fundamentally unfair.”

Separately, ICE Futures US has filed amendments to its Block Trade FAQ clarifying that (i) any party acting principally in a block trade negotiation that plans on engaging in pre-hedging activity will be required, upon request from the exchange, to provide sufficient documentation to support that the persons employed by the party (or its affiliates) involved in the transaction were not acting in an agency capacity during the negotiation and execution of such block trade. and that (ii) communications by a party during block trade negotiations that an order is “being worked” or that the price of the block trade is based on the party’s pre-hedging activities plus a mark-up is evidence of “agency duties [being] owed to a counterparty,” thus precluding lawful pre-hedging.

In the Powerline settlement order the CFTC states that, from about January 2015 through 2019, the registrant allegedly misled clients by failing to adequately disclose that it was acting as the counterparty to its clients’ block trade transactions—not merely as a broker. The CFTC also claimed that Powerline purportedly failed to disclose that it charged clients a markup over the cost at which it was able to execute those block trades as well as the specific amount of the mark-up.

The CFTC also claimed that, because Powerline advised clients on hedging strategies, including specific block trades, it should have also registered as a commodity trading advisor (not just as an IB). Notwithstanding the exemption from CTA registration available under CFTC Rule 4.14(a)(6) to IBs whose advisory business is solely in connection with its brokerage business, the CFTC order states the registrant’s activities were outside the scope of that exemption (a statement Commissioner Mersinger’s dissent characterizes as “cursory” and “conclusory”).

In the parallel NYMEX proceeding, the exchange disciplinary committee found that Powerline solicited its customers for various block trade strategies. Once the customer agreed to a strategy, Powerline would contact a broker to obtain a market for the strategy, allegedly “for its own benefit.” In doing so, the exchange alleged,

“Powerline acted on nonpublic information to obtain a better price from the broker than Powerline solicited from its customer. Once the broker found a counterparty to take the opposite side of Powerline’s trade and after this trade was consummated, Powerline returned to its customer and unwound its position opposite its customer near the originally quoted price.”

Based on those findings, NYMEX determined that Powerline had executed pre-hedged trades for its own account, in violation of the exchange rule that prohibits a broker acting as an “intermediary” from pre-hedging a block trade with a customer in any account that is proprietary to the broker. Under all US exchange rules, the “broker as intermediary” may enter into transactions to offset the position only after the block has been consummated with a customer. (See this Katten advisory for a summary of exchange rules on block trades, EFRPs and other trade practice issues.)

The Powerline settlements are among several recent disciplinary matters alleging that futures market participants were on the wrong side of the pre-hedging prohibition for intermediaries – see the links below for sample recent settlements by COMEX and ICE Futures US, as well. These matters hold some important lessons for market participants looking to minimize their enforcement risk, including (without limitation): it’s not a sufficient defense that your counterparty believed the price it was filled was fair and reasonable; and it’s not sufficient disclosure just to tell your counterparty that you are acting as a principal.

The CFTC’s Powerline order is here; Commissioner Mersinger’s dissenting statement is here. The NYMEX Powerline disciplinary notice is here. Sample recent exchange settlements involving allegations of unlawful pre-hedging activity are here (ICE Futures US) and here (COMEX). The ICE Futures US CFTC submission amending its Block Trade FAQ is here.