Both the Securities and Exchange Commission and the Commodity Futures Trading Commission resumed full operations last week. Promptly, the CFTC and the Chicago Board of Trade resolved coordinated enforcement actions against an alleged spoofer of soybean futures products traded on CBOT. Separately, the SEC filed a supplemental brief with a US federal court in California to augment its effort to set aside a November 2018 decision denying the agency a preliminary injunction against defendants in connection with their presales of an initial coin offering and an ICO of a cryptoasset that the SEC alleged was an unregistered security. The SEC claimed that the court misapplied applicable law related to what constitutes a security as well as the standards for a preliminary injunction. As a result, the following matters are covered in this week’s edition of Bridging the Week:
The next regular edition of Bridging the Week will be distributed on February 19, 2019, because of business travel and the US Presidents’ Day holiday on February 18.
According to both the CFTC and CBOT, during the relevant time, Mr. Crepeau placed smaller bids and offers on one side of a market using automated spread placement functionality while manually entering larger orders on the opposite side of the market that he purportedly did not intend to execute. The CFTC and CBOT alleged that Mr. Crepeau endeavored to induce market participants to purchase or sell his smaller orders through entry of his larger orders, and if successful, he cancelled his larger orders. The two regulators claimed that Mr. Crepeau repeated this trading technique on multiple occasions.
Mr. Crepeau agreed to pay a fine of US $120,00o to settle his CFTC enforcement action and US $30,000 to resolve his CBOT disciplinary matter. He also consented not to trade futures contracts or related options, as well as swaps, or certain other enumerated financial instruments under the CFTC’s oversight for four months.
Separately, the New York Mercantile Exchange resolved a disciplinary action against Sage Refined Products, Ltd. (“SRP”). A NYMEX business conduct committee alleged that the firm executed numerous block trades for customers involving various NYMEX energy products between July and December 2017 but failed to report the executions within mandatory time frames and did not report accurate trade details. The NYMEX BCC also claimed that SRP did not adequately train or supervise its employees. SRP consented to remit a penalty of US $135,000 to settle this matter.
Additionally, Credit Suisse International agreed to pay a fine of US $95,000 for allegedly violating a position limit in the palladium futures contract that became effective as of close of business on May 30, 2018. NYMEX claimed this violation occurred despite the exchange notifying CSI of the position limit during the day on May 30. Finally, Willowbridge Associates Inc. also agreed to a sanction of US $25,000 for purportedly violating a position limit in the Henry Hub National Gas futures contract for one day on June 25, 2018.
Compliance Weeds: Early last year, the CFTC and the Department of Justice coordinated announcements regarding the filing of civil enforcement actions by the CFTC, naming five corporations and six individuals, and criminal actions by the DOJ against eight individuals – including six of the same persons named in the CFTC actions – for engaging in spoofing activities in connection with the trading of futures contracts on US markets. Two of the corporations that resolved their CFTC enforcement actions were Deutsche Bank AG and its wholly owned subsidiary Deutsche Bank Securities Inc., a CFTC-registered futures commission merchant; they agreed to jointly and severally pay a fine of US $30 million. Although the purported problematic trading activity was undertaken by employees of DB, DBSI was named in this action because of its alleged failure to supervise. According to the CFTC, while DBSI maintained a surveillance system that detected many instances of potential spoofing by DB traders, it failed to follow up on “the majority” of potential flagged issues. (Click here for background on the multiple CFTC and DOJ actions in the article “CFTC Names Four Banking Organization Companies, a Trading Software Design Company and Six Individuals in Spoofing-Related Cases; the Same Six Individuals Criminally Charged Plus Two More” in the February 4, 2018, edition of Bridging the Week.)
In 2016, the CFTC named Advantage Futures LLC, another FCM, in an enforcement action related to the firm’s handling of the trading account of one customer in response to three exchanges’ warnings, among other matters. The firm and the two officers that were named as defendants agreed to pay a fine of US $1.5 million to resolve the CFTC action.
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 considered 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 [exchanges'] 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 the three exchanges. However, Advantage failed to augment its oversight of the trader’s remaining trading or control his access to other exchanges “despite knowing that he employed the same strategy across all markets.” (Click here for background in the CFTC enforcement action against Advantage Futures 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.)
Both the DBSI and Advantage cases suggest that the CFTC believes that FCMs have some type of oversight responsibility related to their customers’ trading to help ensure market integrity, and must take some appropriate action when they have knowledge of potential wrongdoing.
The CFTC’s aggressive view of law regarding FCMs supervisory obligations in the context of potential customer or affiliate disruptive trading has not been tested by a judicial decision. However, to help minimize the possibility of being subject to a CFTC enforcement action, FCMs should likely have procedures to internally escalate potential allegations of wrongdoing by customers and affiliates received from regulators and other third parties, and should consider proactive monitoring of some type on an ongoing basis for trading that may violate the law. The challenge of monitoring, however, is calibrating a system to identify meaningful potential exceptions so as not to be inundated by too many false positives and to ensure that data received and evaluated by the system does not unintentionally exclude any relevant order information. However, all alerts should be reviewed in some manner, and those reliably suggesting potential problematic conduct should be followed up. All monitoring should be documented.
Generally, Mr. Giancarlo advocated on behalf of recent rule proposals issued by the CFTC to modify swaps trading requirements on SEFs. In its proposals, the CFTC recommended, among other things:
(Click here for background on the CFTC’s recent proposed amended SEF trading rules in the article “Over One Commissioner’s Vehement Dissent, CFTC Authorizes Publication for Comment Proposed Rules to Overhaul Swaps Trade Execution Requirements on Trading Facilities” in the November 11, 2018, edition of Bridging the Week.)
In a virtual appearance before the ABA Business Law Section, Derivatives and Futures Law Committee Winter Meeting, Mr. Giancarlo claimed that the CFTC’s proposals are generally warranted because the current SEF regime’s reliance on a series of no action letters and other temporary relief and guidance is untenable and easily reversible by a future administration, and because the current restrictions on execution may contribute to trading risks during a future liquidity crisis.
However, Mr. Giancarlo acknowledged that while he heard “strong interest” in replacing existing no-action relief and guidance with formal rule making, and eradicating the “most burdensome and unworkable” aspects of current SEF compliance during recent reach-outs to swaps market participants, he also received some criticism regarding the CFTC’s proposal, particularly with regard to the process and timing of bringing new swaps products into scope; recommended restrictions on off-SEF, pre-trade communications; and “simplified revisions” for impartial access.
Separately, in a pre-recorded appearance at the Commodity Markets Council State of the Industry Conference, Mr. Berkovitz criticized what he viewed as an attempt to dismantle the existing, generally successful, SEF regime. According to Mr. Berkovitz, “[t]here is plenty of data and economic evidence showing that the Commission’s current SEF rules have led to more competition, greater liquidity, more electronic trading, better price transparency, and lower prices for swaps that are traded on regulated platforms.” He opposed adoption of the proposed SEF trading rule amendments which he believes would lead to the creation of one class of markets where end users and proprietary traders would arrange purchases and sales of swaps with swap dealers, and a second category of markets, where swap dealers would exclusively trade with other swap dealers to lay off their risks at preferable prices that solely dealers could access.
Mr. Berkovitz indicated he was not opposed to targeted improvements to existing SEF rules that would expand floor trader registration, rationalize bank capital requirements that inhibit futures commission merchants to clear swaps, abolish name give-up and enable average pricing.
In his presentation before the ABA committee, Mr. Giancarlo, also advocated for the CFTC to replace its current entity approach to cross-border application of its swap regime with one based on “regulatory deference to third country regulatory jurisdictions that have adopted the G-20 swaps reforms” as proposed in an October CFTC white paper. (Click here for details regarding the white paper in the article “CFTC Proposes to Amend Rules to Track Previously Granted No-Action Registration Relief for CTAs and CPOs; Issues Cross-Border Swaps Reform White Paper” in the October 14, 2018, edition of Bridging the Week.) Mr. Giancarlo indicated that he will soon formally direct CFTC staff to draft cross-border rule proposals paralleling recommendations in the white paper for public comment.
My View: Last week the International Swaps and Derivatives Association published a thoughtful discussion of how differences in global standards in connection with derivatives could be addressed – particularly those related to capital, margin, clearing, trade execution and extraterritoriality. Most importantly, ISDA argued, “policy makers and market participants should continue to affirm the value and benefits of global markets in generating sustainable economic growth.” Specifically, policy makers should recognize how global markets contribute to sustained economic growth; reduce the gap between global standards and national regulation to ensure greater consistency; and implement risk-based frameworks to evaluate and recognize the comparability of different regulatory regimes. For smaller jurisdictions with limited market activity, ISDA recommended implementing global standards “when and where appropriate.” ISDA’s report is worth considering in light of the CFTC’s recent initiatives on SEF execution and its cross-border approach. (Click here to access the ISDA report, “Regulatory Driven Market Fragmentation.”)
Kudos also to Chairman Giancarlo for proactively seeking out swaps markets participants and listening to their concerns, and apparently being willing to reflect on what he heard in the next stage of staff drafting of SEF trading reforms.
Although entities with ten percent or more common ownership may be eligible to disaggregate their future equivalent positions to assess their speculative position limit compliance relying on the so-called “owned entity exemption,” such relief is contingent on each entity having no shared employees “that control the trading decisions of either.” (Click here to access CFTC Rule 150.4(b)(2).) The rule refers to trading generally and does not limit the term “trading” to derivatives. Previously, DMO staff authorized the application of the owned entity exemption where related entities were aware of cash market trading decisions of the other. (Click here to access CFTC No Action Letter 17-37, August 10, 2017.) Staff’s current no action relief is effective solely through April 12, 2019.
(Click here for background on the CFTC’s owned entity exemption in the article “CFTC Adopts Final Rules Related to Aggregation of Positions and Owned Entity Exemption; Re-Proposes Position Limits Rules” in the December 11, 2016, edition of Bridging the Week.)
In December 2018, the SEC first argued for a rehearing of the preliminary injunction denial, claiming that, in its November decision, the court misapplied existing law in saying that the SEC must prove an investment is a security based on the beliefs of individual investors rather than on an objective measure of the nature of the investment being offered to the public and imposed an “artificially high burden” on the SEC to obtain injunctive relief. The SEC argued that defendants promoted BLVs as if they were securities and that their purported wrongful conduct did not stop until after the court imposed the TRO against the defendants and they retained counsel. The SEC said that not granting a preliminary injunction solely because defendants promised to stop their offering ignored the gravity of defendants’ alleged prior unlawful conduct.
In response, defendants argued that the court had reasonably demonstrated there was no likelihood of future wrongdoing, and, in fact, no wrongdoing has occurred for the two months since the court’s order. Defendants also said that the court correctly applied applicable law in determining that the SEC had not proven that BLV tokens were securities.
According to defendants, the court properly concluded that the SEC provided “no evidence” to support that investors expected profits (i.e., capital appreciation derived from “the development of [their] initial investment”) or a sharing of earnings generated from the use of their invested funds as they were required by applicable precedent. The defendants said this is required under the Supreme Court’s 1946 decision of SEC v. WJ Howey relied on by the SEC (click here to access this Supreme Court decision). The SEC discounted defendants’ arguments in a reply paper filed last week, reiterating arguments made in their first reconsideration brief.
In other legal and regulatory developments involving cryptoassets:
Although the appellate court conceded that bitcoin is not currency under Florida law, it said that bitcoin falls under the definition of payment instrument because it constitutes monetary value which means “a medium of exchange, whether or not redeemable in currency.” The appellate court also rejected defendant’s argument that he was not a money transmitter because he did not receive currency, monetary value or payment instruments for the purpose of transmitting the items to a third party, but solely acted as a seller of bitcoin. The court noted that nothing in the relevant Florida statute requires transmission to a third party for a person to qualify as a money transmitter; this contrasts with a parallel provision of US federal law overseen by the Financial Enforcement Crimes Network of the US Department of Treasury. (Click here to access 31 CFR § 1010.100(ff)(f)(i)(A).) The relevant Florida law solely states that an MSB is a person who "...receives currency, monetary value or payment instruments for the purpose of transmitting the same.”
In his criminal charges, Mr. Espinoza was accused of receiving fiat currency from an undercover detective involved in unlawful conduct and sending bitcoin to the detective. The appellate court ruled that this conduct constituted the receipt of currency for the purpose of transmitting monetary value or payment instruments – mainly bitcoin – which qualified as both monetary value and payment instrument.
Legal Weeds: During September 2018, a federal court in Brooklyn, New York, declined to dismiss a criminal indictment against Maksim Zaslavskiy charging him with securities fraud and related offenses in connection with two cryptocurrency investment schemes and their related initial coin offerings. (Click here for background in the article “Brooklyn Federal Court Rules ICO-Issued Digital Assets Could Be Securities” in the September 16, 2018, edition of Bridging the Week.)
The different outcomes between Blockvest and Zaslavskiy – although resting on different preliminary presentations of facts – may herald an ultimate determination by a higher court as to what the expectation of profits accomplished through the efforts of others prong of the Howey test actually means. Although the Department of Justice and SEC have repeatedly argued that cryptoassets issued as part of presales to ICOs and ICOs are most often securities, investors in such digital assets do not typically expect to share any income from the project identified with the ICO and the value of their cryptoassets only remotely, if at all, is tied to the value of such projects. Moreover, investors in digital assets will likely have no claims on the assets of a project if the project goes bankrupt.
For further information:
CFTC and CBOT Resolve Coordinated Enforcement Actions Against Alleged Soybean Spoofer:
CFTC Granted Delay to Consider Appealing Adverse Attempted Manipulation Decision:
Different Roads to Travel for Swap Execution Reform Proposed by CFTC Chairman and New Commissioner:
FINRA Finds High Percentage of Order Routing Through Affiliated ATSs = Lower Order Fill Rate + Higher Execution Costs:
Florida Appellate Court Rules Seller of Bitcoin Engaged in Money Service Business:
Global Bank and NY Branch Fined US $40 Million by NY Financial Regulator for Attempted Manipulation of FX Markets:
International Industry Organization Publishes Smart Contract Legal Guidelines:
New NFA CPO Internal Control Requirements Effective April 1:
Related Firms Authorized by CFTC Staff Not to Combine Futures Positions For Speculative Limits Purposes Despite Shared Employee Trading Physical Commodities For Both Entities:
SEC Again Requests California Federal Court to Reconsider Denial of Preliminary Injunction Against Alleged Seller of Purported Unregistered Security in ICO:
Try It Again, VanEck SolidX Bitcoin Trust:
The information in this article is for informational purposes only and is derived from sources believed to be reliable as of February 2, 2019. No representation or warranty is made regarding the accuracy of any statement or information in this article. Also, the information in this article is not intended as a substitute for legal counsel, and is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The impact of the law for any particular situation depends on a variety of factors; therefore, readers of this article should not act upon any information in the article without seeking professional legal counsel. Katten Muchin Rosenman LLP may represent one or more entities mentioned in this article. Quotations attributable to speeches are from published remarks and may not reflect statements actually made. Views of the author may not necessarily reflect views of Katten Muchin or any of its partners or other employees.
Gary DeWaal is currently Special Counsel with Katten Muchin Rosenman LLP in its New York office focusing on financial services regulatory matters. He provides advisory services and assists with investigations and litigation.
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Bridging the Week by Gary DeWaal: January 28 – February 1 and February 4, 2019 (Spoofing; SEF Trading; Security Tokens; Bitcoin Sales)Jump to: Automated Trading Systems and Connectivity Bitcoin Ecosystem Block Trades and EFRPs Bridging the Week Cleared Swaps Cryptosecurities Legal Weeds Managed Money Manipulation My View Position Transfers Trade Practices (including Disruptive Trading)