A bit of new and a bit of old highlighted international financial regulatory developments this past week. The Commodity Futures Trading Commission brought its first action invoking a new prohibition under its business conduct standards for swap dealers, while Peregrine Financial Group made news when a US federal court permitted two lawsuits to proceed against one of the banks that held the firm’s customer segregated funds. Meanwhile a new CFTC commissioner invoked Smoot-Hawley to implore cooperation among international regulators regarding the oversight of swaps. Smoot-Hawley? Talk about a great Final Jeopardy™ answer!

Court Permits Customer and IB Claims to Proceed Against U.S. Bank Over Peregrine Collapse

A US federal court in Illinois authorized two lawsuits arising from the collapse of Peregrine Financial Group to proceed against U.S. Bank, N.A., rejecting requests from the bank to dismiss the proceedings. Peregrine customers brought one lawsuit, while Fintec Group, Inc., a former introducing broker to Peregrine, commenced the other. Both cases were brought as potential class action lawsuits.

Peregrine was a futures commission merchant registered with the Commodity Futures Trading Commission until July 2012 when it filed bankruptcy following the revelation that Russell Wasendorf, Sr., its principal owner and chief executive officer, had committed fraud by using customer funds for his own purposes. Initial estimates were that Peregrine customers’ cash shortfall might exceed US $200 million or more.

U.S. Bank was the principal bank where Peregrine maintained customer funds.

In the customer lawsuit, plaintiffs claimed that U.S. Bank was liable for funds misappropriated by Mr. Wasendorf that had been deposited with it by Peregrine on the basis of a number of legal theories. The court rejected plaintiffs’ claims that U.S. Bank aided and abetted Peregrine’s and Mr. Wasendorf’s own violations, on the grounds that U.S. Bank had no actual knowledge of Mr. Wasendorf’s fraud. The court also rejected a claim of negligence against U.S. Bank because the plaintiffs were not direct customers of the bank, and thus the bank had no duty of care towards them. However, the court allowed plaintiffs’ lawsuit to proceed based on their claims of U.S. Bank’s breach of fiduciary duty, fraud by omission and a violation of an Illinois law dealing with the obligations of fiduciaries.

According to the court, Peregrine established a specially designated customer segregated account at U.S. Bank. However, “[d]espite the fact that the [relevant account] was a customer segregated account, U.S. Bank employees performed numerous transactions out of the [relevant account] for non-customer purposes.” These transactions included transferring substantial funds to personal accounts of Mr. Wasendorf and his wife (including almost US $2.5 million to his wife in connection with the couple’s divorce) and over US $24 million to the account of another company owned by Mr. Wasendorf. The court claimed that Mr. Wasendorf also granted a contractual right of setoff to the Peregrine customer segregated account in connection with guaranties provided to U.S. Bank by Mr. Wasendorf and his wife for a US $6.4 million loan to build a new Peregrine headquarters building. The court claimed that these and other alleged facts are sufficient, at this time, to support plaintiffs’ action:

Although taken individually, [these facts] are not sufficient to establish bad faith, when considered together, they suffice at this state to allow Plaintiffs to move forward with their claims.

Fintec made similar factual claims in its lawsuit, as did the customers. The court dismissed the majority of Fintec’s legal theories. However, the court permitted Fintec’s lawsuit to proceed based on alleged violations of relevant federal law dealing with the bank’s obligations in connection with holding customer funds. The court reasoned that, because U.S. Bank apparently held funds in the customer segregated account that Fintec had deposited with Peregrine to guarantee the trades of its customers, Fintec’s funds were “in connection” with making futures contracts. The court found this nexus sufficient to permit Fintec to proceed on its claims that U.S. Bank violated federal law directly, as well as that it aided and abetted a federal law breach by Peregrine.

CFTC Commissioner Giancarlo Invokes Smoot-Hawley to Remind Global Regulators of the Dangers of Uncoordinated Swaps Regulation

New CFTC Commissioner J. Christopher Giancarlo used the occasion of a derivatives industry conference in Geneva, Switzerland to plea for better cooperation among international regulators in implementing over-the-counter derivatives clearing and trading mandates initially proposed at a G-20 summit in Pittsburgh, Pennsylvania in 2009.

Invoking the damaging consequences of the US unilaterally implementing trade protection measures following the US stock market crash of 1929—through passage of the Smoot-Hawley Tariff Act of 1930—Mr. Giancarlo argued against unilateral action by regulators—including the CFTC—that could lead to “[a] trade war over swaps market clearing and execution that will be harmful for the US.” He claimed such a trade war would also hurt Europe.

According to Mr. Giancarlo, Smoot-Hawley was enacted at the time to help the US manufacturing and agricultural sector. However, he claimed, promoters of the law failed to give adequate consideration to the international reaction to unilateral US action:

Smoot-Hawley was interpreted as a declaration of trade war at a critical time in the world economy. Smoot-Hawley made the US a special target of discriminatory trade retaliation from some of the US’ largest and most important trade partners. It led other countries to form preferential trading blocs that discriminated against the United States, diverting world trade and delaying economic recovery on both sides of the Atlantic.

Mr. Giancarlo acknowledged that Smoot-Hawley and international reaction did not cause what ultimately came to be known as the Great Depression, but “it made it worse.”

The new commissioner identified the failure of European regulators to recognize US clearinghouses as “qualifying ” and US imposition of trading rules on non-US execution forums doing business with US persons “contrary to common practice in global markets” as evidence of uncoordinated regulation that has already contributed to global market fragmentation. (If European regulators do not recognize US clearinghouses as qualifying by December 15, European-based banks will face prohibitive capital charges when conducting business through such entities.)

Citing some recent signs of progress between the CFTC and European Commission leadership for “a sound and practical basis for regulatory and supervisory cooperation,” Mr. Giancarlo urged, most immediately, for a resolution of the impasse over the status of US clearinghouses:

I sincerely hope that we can fulfill the important goals that the G-20 set for us in Pittsburgh and avoid falling into a misguided global trade war over regulation of derivative financial products. A global economy that is just starting to show signs of recovering from the “Great Recession” cannot bear the reduction in trade and fragmented financial markets that is a looming possibility.

Barclays Entities Settle With UK FCA Over Client Money Rule Breaches and With US SEC for Investment Advisor Compliance Issues

Two Barclays entities on different sides of the Atlantic Ocean settled regulatory matters resulting in sanctions of over US $75 million.

In one action, Barclays Bank plc settled charges with the UK Financial Conduct Authority that alleged it failed adequately to follow requirements related to the protection of client assets. For this, Barclays agreed to pay a financial penalty of GBP 37,745,000 (US $61.3 million).

In the other action, Barclays Capital Inc. agreed to pay a fine of US $15 million to the US Securities and Exchange Commission and implement certain remedial measures for allegedly failing to maintain an adequate compliance system in connection with its wealth management business.

According to the FCA, from November 1, 2007, through January 24, 2012, Barclays Bank failed to maintain “adequate and effective organizational, control and risk management systems” regarding 95 external accounts where client custody assets  were held with sub-custodians outside the Barclays Group, and did not “arrange adequate protection for, maintain its own books and records and perform its own reconciliations” related to approximately GBP 16.5 billion (US $26.8 billion) of client custody assets for which it was responsible.

FCA made clear that Barclays Bank’s failings were solely within its investment banking division. No other bank customers or operations were impacted.

FCA noted that, although Barclays Bank self-reported its failings, it did not detect its issues for over three years, and it took approximately eight months for the bank to identify the number of accounts in breach of requirements. FCA acknowledged, however, that no customers were harmed as a result of the bank’s issues and that the bank did not act “deliberately or recklessly.”

Separately, the SEC found that Barclays Capital did not adequately enhance the compliance system of its wealth management business after it acquired the private investment management business of Lehman Brothers in 2008. The SEC also claimed that the firm did not put in place adequate policies and procedures to prevent violations of relevant law and to keep certain required books and records.

Among other things, said the SEC, Barclays Capital engaged in certain principal transactions from January 2009 to December 2011 without making written disclosures and obtaining client consent, as required by law; charged commissions and fees and earned revenue from September 2008 through December 2011 that were not in accordance with client disclosures; and did not ensure that client funds and securities over which it had custody were subject to surprise examinations by an independent public account, as required by an SEC rule.

In agreeing to the settlement, the SEC acknowledged Barclays Capital’s cooperation and the prompt remedial actions it took after learning of its issues, as well as the reimbursement to customers of approximately US $3.8 million, including interest.

In addition to paying a fine, Barclays Capital agreed to retain an independent compliance consultant to review discrete aspects of the firm’s advisory business and issue recommendations, which the firm has committed to adopt unless unreasonable.

And briefly:

• CFTC Sues Trader for Fraud and Unauthorized Swap Trades: Gregory Evans, a former employee of an unnamed futures commission merchant and provisionally registered swap dealer, was sued by the Commodity Futures Trading Commission for executing 30 unauthorized bilateral swap transactions opposite a customer in order to hide trading losses from his customers and his employer. The unauthorized trades are alleged to have occurred from January through July 2013 and resulted in approximately US $1.2 million of trading losses for the aggrieved customer that were later reimbursed by the firm. According to the CFTC’s complaint, filed with a US federal court in Missouri, Mr. Evans embarked on his unauthorized actions after he engaged in authorized but losing transactions for one customer, and sought to hide these losses and increase his compensation by trading without authority for another customer. The CFTC charged Mr. Evans with general fraud, fraud by deceptive devices or contrivances (under the CFTC’s new anti-fraud based manipulation authority), fraud in violation of business conduct standards for swap dealers and unauthorized transactions.

• Ontario Securities Commission Issues Guidance Regarding Unsolicited Trade and Hedger Exemption for Unregistered Foreign Dealers Facilitating Futures Transactions With Ontario-Based Customers: The Ontario Securities Commission issued a staff notice that appears to restrict, if not eliminate, certain exemptions under applicable law potentially relied on by non-OSC registered foreign brokers (including US futures commission merchants) for trading futures and options on behalf of Ontario-based persons. Under relevant futures law in Ontario, registration of a dealer (what is known as a broker or FCM in the US) is not required in respect of “a trade in a contract by a hedger through a dealer” or a “trade in a contract executed on an exchange [outside Ontario] … from an order placed with a dealer who does not carry on business in Ontario, not involving any solicitation by or on behalf of the dealer.” In connection with the so-called “unsolicited trade” exemption, the staff notice claims this was meant solely to apply to “occasional, isolated trades” for Ontario-based customers that are not solicited by a foreign broker. It was not intended “to permit the operation of unsolicited order-execution accounts,” says the staff notice, because “this would constitute trading with regularity” or trades introduced by third parties (for example, by introducing brokers or finders) for which commissions are paid. The staff notice also claims that foreign brokers that regularly conduct business with a client under another exemption—for example a securities exemption—cannot rely on the unsolicited trade exemption to conduct futures transactions with the same customer. In addition, the staff notice claims that the “hedger” exemption is flat out “not available to an unregistered foreign [broker] that wishes to trade with [a] hedger” even if the proposed transactions are bona fide hedges. OSC will continue to consider specific requests for registration exemptions from foreign brokers wishing to do futures business with certain qualified Ontario-based persons modeled under the exemptive regime for international firms in the securities industry.

• The Other Shoe Drops: After Previously Fining FirstRand Bank for Unlawful Pre-Execution Discussions, CFTC Now Fines the Counterparty, Absa Bank: A few weeks ago, the Commodity Futures Trading Commission commenced and settled an enforcement action against South African-based FirstRand Bank, Ltd. for engaging in noncompetitive corn and soybean futures trades on the Chicago Board of Trade from January 2009 to August 2011. The respondent had engaged in pre-trade phone conversations with its counterparty, believing such conversations were legal. This is because the CBOT transactions were done in conjunction with contracts traded on the Johannesburg Stock Exchange’s SAFEX Commodity Derivatives Market where certain prearranged trades between market makers are permitted. (Click here for more on this action in the article “CFTC Fines FirstRand Bank for Unlawful Pre-Execution Discussions Related to Soybean Futures Trades” in the August 18 to 29 and September 2 edition ofBridging the Weeks .) Last week FirstRand’s counterparty in these transactions, Absa Bank Ltd, also settled an enforcement action brought by the CFTC based on the same facts and rule breach allegation for payment of a US $150,000 penalty.

• Father and Son Sanctioned by CFTC for Position Limit Violations: Kennith Wayne Thrasher and Kennith Luke Thrasher, father and son, respectively, were the subject of a CFTC enforcement action over alleged violations of the spot month speculative position limit established by the Chicago Mercantile Exchange for live cattle futures contracts. The violations were alleged to have occurred on 12 trading days in February 2013, and to have involved at least 190 to 390 contracts over the limit. According to the CFTC, the violative positions were maintained in accounts of two companies where the father owned limited partnership interests and had power of attorney to trade both companies' accounts. The son, during the relevant time, is alleged to have placed orders for both companies' accounts. The CFTC claimed the father and son “directly or indirectly controlled the trading” in both accounts, and thus the positions of the accounts had to be aggregated for purposes of applying the CME’s limits. Only on a combined basis did the accounts exceed the limits. To resolve this matter, the father and son agreed to pay a fine of US $525,000.

• Important Reminders Resonate From Recent CME Group and ICE Futures U.S. Disciplinary Actions: CME Group and ICE Futures U.S. brought and resolved a number of disciplinary actions last week, which involved a plethora of different rules. CME settled three unrelated actions that, had the underlying facts occurred beginning September 15, would likely have been charged as violations of its new disruptive trading practices prohibition. The three actions, involving John Brogran, Danny Giamalis and Anuj Singhal, all centered on trading activities that were alleged not to be intended for bona fide purposes. Each respondent was charged with violating the CME’s general prohibition against committing acts detrimental to the interest or welfare of the exchange and engaging in dishonorable or uncommercial conduct. Another respondent, Jilin Grain Group Import and Export Co., Ltd. was charged with failing to supervise traders who executed 13 wash trades for 1,360 soybean and corn futures contracts purportedly to move positions among accounts. The firm was also charged with not assigning unique identifications (so-called “Tag50 user IDs”) to each of its Globex traders. Towers Research Capital Investments, LLC likewise was sanctioned by the CME for not assigning unique identifications to separate algorithms it used, but additionally for entering an excessive number of order messages in the March 2011 corn futures contract on October 18, 2010, because of a technical issue, and unintentionally self-matching through different trading groups a number of transactions on multiple dates in December 2011. Finally, Aster Commodities DMCC was charged by CME with wash trades and prearranged transactions for not waiting the requisite time to place one party’s order, after the party and a counterparty engaged in pre-execution communications, while ADM Investor Service, Inc. was subject to multiple actions by CME for making trade adjustments to various futures contracts that resulted in an overstatement of open interest. ICAP Energy LLC settled a disciplinary proceeding with ICE Futures U.S. for submitting block trades below the applicable threshold and outside the applicable reporting period, while Merrill Lynch Commodities, Inc. was sanctioned by ICE Futures U.S. for violating spot month position limits on four days. MLC also was alleged on one occasion to have failed to supervise an employee whose violation of position limits was a repeat offense.

Compliance Weeds: Reports of exchange disciplinary actions provide an excellent source of material to include in internal training of staff as they address a diverse set of day-to-day requirements and topics relevant to a number of internal departments (for example: sales, operations, information technology). Most regulatory organizations provide the ability to receive notices of these actions automatically.

And even more briefly:

• October 9 CFTC Global Markets Committee to Address NDFs and Bitcoins: The CFTC Global Markets Advisory Committee will meet on October 9. The two topics on the agenda are the appropriateness of a clearing mandate for non-deliverable forwards involving foreign exchange and the CFTC’s jurisdiction over derivatives contracts based on Bitcoins. (Click here to access an excellent background on Bitcoin, “Center for Financial Stability—Private Roundtable: Bitcoin (October 30, 2013) featuring two Katten Muchin Rosenman LLP partners: Evan Greebel and Kathleen Moriarty.)

• EUREX to Introduce New Margining System—Prisma: Eurex Clearing AG announced its schedule to stop using its current risk-based margin methodology—RBM—and migrate exclusively to its new margin system, Prisma. Prisma is a portfolio-based risk methodology. RBM and Prisma are currently running parallel and will continue to do so until the end of 2015, when all exchange-traded derivatives will be removed from RBM. RBM will be fully decommissioned by the end of 2016 when all remaining Eurex Clearing products are removed.

• LME Launches LME Clear: The London Metal Exchange announced the successful launch of LME Clear, the new LME clearinghouse. On September 22, LME migrated all positions of its members from LCH.Clearnet Ltd to LME Clear.

• Shanghai Gold Exchange Opens to International Clients: The International Board of the Shanghai Free Trade Zone was launched by the Shanghai Gold Exchange on September 18, providing international investors access to China’s gold exchange. The International Board trades both spot and forward gold and is accessible to international investors through international members who qualify under SGE requirements.

• CFTC Publishes Text of Proposed Swaps Margin Rules and Final Rule Related to Utility Operations-Related Swaps: The CFTC published the text of its proposed rules related to uncleared swaps and its final rule related to operations-related swaps with certain government-owned natural gas and electric utilities. 

• LME Explains LME: The London Metal Exchange published a revised guidance on its structure, market terminology and methods for order execution. This document helps explain some of the practices of the LME that oftentimes baffle followers of futures on the North American side of the Atlantic Ocean. (Click here to see a summary of this guidance in the article “London Metal Exchange Provides Revised Guidance on Structure, Terminology and Order Execution” in the September 26 edition of Corporate and Financial Weekly Digest by Katten Muchin Rosenman LLP.)

• BIS Reports on Collateral Management: The Bank for International Settlements Committee on Payments and Market Infrastructures issued a report examining evolving services provided by collateral management service providers to meet increasing collateral demands in light of global financial reforms following the 2008 financial crisis.