A federal judge said that it is not a violation of federal law for a trading firm and its chief executive officer to be smarter than their counterparties in ruling against the Commodity Futures Trading Commission in an enforcement action alleging manipulation and attempted manipulation. Separately, the National Futures Association proposed amendments to its guidance to members regarding the contents of their information systems security programs. As a result, the following matters are covered in this week’s edition of Bridging the Week:
A US federal court in New York City ruled that the Commodity Futures Trading Commission did not meet its burden of proof in its enforcement action against DRW Investments, LLC and Don Wilson, its chief executive officer. The CFTC had charged the defendants with manipulation and attempted manipulation of the IDEX USD Three-Month Interest Rate Swap Futures Contract from January 24 through August 12, 2011.
The court held that the defendants’ trading activities were legitimate and were consistent with their view that the futures contract’s design was flawed and that the futures instrument was inherently more valuable than a comparable over-the-counter contract. According to the court, “[i]t is not illegal to be smarter than your counterparties in a swap transaction, nor is it improper to understand a financial product better than the people who invented that product.”
The CFTC initially filed charges against the defendants in 2013.
According to the Commission, DRW established a long position in the Three-Month Contract beginning in August 2010. Afterwards, alleged the CFTC, beginning in December 2010, the defendants placed bids “that DRW knew would never be accepted” to artificially influence the settlement prices in their favor during the 15-minute period that most influenced settlement prices on at least 118 trading days, in a “banging the close”–type scheme.
A four-day bench trial before the Hon. Richard Sullivan ensued in December 2016. Afterwards, attorneys for the Commission argued during their closing argument that it was the intent of defendants to produce a “price distortion” through placement of “illegitimate bids during the closing period day after day for seven straight months” that favored defendants’ existing positions by prompting favorable settlement prices. Among other things, said the Commission, defendants’ bids were illegitimate because they knew there was no market interest on the other side.
The court, in a decision by the Hon. Mr. Sullivan – now a judge on the Circuit Court of Appeals for the Second Circuit – rejected the CFTC’s arguments that the defendants’ conduct constituted manipulation or attempted manipulation.
The court said defendants determined that, at the time, a long position in the Three-Month Contract was more valuable than a corresponding long position in an OTC swap contract because the futures instrument did not appropriately account and adjust for long position holders receiving variation margin payments when interest rates were rising, while short position holders received variation margin payments when interest rates were declining. Long position holders of Three-Month Contracts thus received their variation margin payments at a better time to invest. This s0-called "convexity effect" did not typically exist in corresponding OTC swaps in 2011 as no variation margin passed between counterparties, observed the court. As a result, long positions holders of Three-Month Contracts had a more advantageous holding than holders of a corresponding OTC swap instrument.
In response, said the court, each day, the defendants would place bids during the closing periods below and up to their calculation of fair value. The court acknowledged these bids helped increase the value of defendants’ open positions in the Three-Month Contract by impacting settlement prices. However, the court found that defendants’ trading was consistent with their quantitative analysis, and they were always interested to attract counterparties and obtain executions. According to the court, the defendants “made bids with an honest desire to transact at those prices, and … they fully believed the resulting settlement prices to be reflective of the forces of supply and demand.”
In order to prove manipulation, said the court, the CFTC had to show that defendants had the ability to influence market price, an artificial price existed, defendants caused the non-bona fide price, and defendants intended to cause the non-legitimate price. To show attempted manipulation, explained the court, the Commission did not have to show an artificial price existed, but had to show that defendants intended to cause an artificial price. However, the court ruled that it was not manipulation or attempted manipulation for defendants to take advantage of flawed exchange rules that were public information where their bids reflected their bona fide perception of fair value and were designed to induce liquidity. The IDCH settlement prices were not artificial, ruled the court, and defendants did not intend to cause an illegitimate settlement price through their actions.
The court noted that, during trial, the CFTC “unrelentingly” also described defendants’ conduct as “banging the close.” While acknowledging that courts have not precisely defined this term, the court said that defendants’ trading activities were not captured by its common meaning as agreed by the parties. “[A] slogan is a poor substitute for evidence, particularly where the slogan doesn’t fit the facts of the case,” said the court.
The Three-Month Contract was offered on the NASDAQ OMX Futures Exchange (NFX) during the relevant time and was cleared through the International Derivatives Clearing House. The Three-Month Contract was delisted by NFX on December 16, 2011, for failing to attract liquidity.
In response to the Court's verdict, DRW and Mr. Wilson issued the following statement:
We are gratified by the Court’s decision, which confirms our long-held position that our trading activity was lawful, legitimate and in line with market regulation. Importantly, the Court affirmed that artificiality is required for market manipulation to have occurred. Today’s decision upholds the principles of price discovery, transparency and integrity in the markets.
(Click here for a greater discussion of the closing arguments in the defendants’ trial and additional background on the CFTC enforcement action in the article “Judge Questions CFTC’s Theory of Markets in DRW Alleged Manipulation Case During Closing Arguments” in the December 11, 2016 edition of Bridging the Week.)
Here defendants took advantage of a design flaw in an exchange futures contract and settlement rules to benefit their existing position in the relevant Three-Month Contract. The court held this was not manipulation or attempted manipulation because the CFTC failed to meet its burden of proof that the defendants specifically intended to cause an artificial price, let alone caused an artificial price. Indeed, said the court, defendants’ bids were consistently lower than its objectively supported view of the contract’s true value. According to the court, “DRW’s bidding practices actually contributed to price discovery rather than price manipulation.”
Moreover, if defendants’ bids were above market value as alleged by the Commission, market participants would have “surely” accepted such bids knowing they could profit when prices returned to their natural levels. The court criticized the Commission for making a “tautological’ argument that prices were artificial solely because defendants attempted to “affect prices.” However, said the court, this position, if “taken to its logical conclusion would effectively bar market participants with open positions from ever making additional bids to pursue future transactions.”
In its complaint against defendants, the CFTC solely relied on the traditional provisions in relevant law prohibiting manipulation and attempted manipulation because the challenged conduct occurred prior to the effective date of a new provision of law prohibiting fraud-based manipulation under the Dodd-Frank Wall Street Reform and Consumer Protection Act. (Click here to access 7 U.S.C. § 9(3) (prior to D0dd-Frank, effectively 7 U.S.C. § 9) and here for 7. U.S.C. § 13(a)(2) – the CFTC’s traditional anti-manipulation authorities. Click here to access 7 U.S.C. § 9(1) – the CFTC’s new Dodd-Frank authority.)
Under this new provision, it is now prohibited for any person to engage in “any manipulative or deceptive device or contrivance” in connection with any swap, or a contract of sale of any commodity in interstate commerce or any futures contract in violation of any rule the CFTC might adopt. The CFTC has, in fact, adopted a specific rule related to this statutory provision, and has used the law and rule to prosecute a wide swath of conduct – from its first use by the CFTC in a 2013 enforcement action against JP Morgan in connection with its “London Whale” episode to subsequent enforcement actions involving illegal off-exchange metals transactions; claims of more traditional manipulation of wheat; allegations of spoofing; and charges of insider trading. (Click here to access CFTC Rule 180.1; click here for background on the CFTC's use of its Dodd-Frank authority in the article, "Ex-Airline Employee Sued by CFTC for Insider Trading of Futures Based on Misappropriated Information" in the October 2, 2016 edition of Bridging the Week.) The CFTC claims it now has broad authority to prosecute persons for their intentional or reckless employment or use of any manipulative device, scheme or artifice to defraud. (Click here for background on the CFTC's new authority in the Federal Register Release adopting CFTC Rule 180.1. Click here, however, to access a discussion regarding a challenge to the CFTC’s position regarding its new authority in the article “California Federal Court Dismissal of CFTC Monex Enforcement Action Upsets Stable Legal Theories” in the May 6, 2018 edition of Bridging the Week. The Monex decision is currently on appeal. )
However, even if it was able to apply its new authority, the CFTC most likely would have lost an enforcement action against defendants premised on the facts of this case. Although under its Dodd-Frank fraud-based anti-manipulation authority the CFTC does not have to prove that a price or market effect existed to prevail in a manipulation claim, it still has to evidence an intent to create false prices or at least some type of recklessness which led or could have led to non-bona fide results. Here, however, the Court found that defendants solely intended to achieve legitimate prices. They placed bids relying on the public terms of the flawed Three-Month Contract that reflected their view of the contract’s true value. They did so with an intent to attract liquidity and effectuate execution and not to mislead others. Settlement prices that came about because of their activities reflected fully legitimate, not illegitimate, market activity, said the court.
In the court’s view, the CFTC simply did not present sufficient evidence to support its charges against defendants and “persisted in its cry of market manipulation based on little more than an ‘earth is flat’ style conviction that such manipulation must have happened because the market remained illiquid.” That strategy was not enough to sustain the CFTC’s case under its traditional manipulation authority and, in my view, would most likely not have been sufficient under its new, broader authority.
NFA’s proposed amendments will require that members provide training to their employees regarding its ISSP upon hiring, at least annually, and more frequently “if circumstances warrant.” Members will be required to identify the topics of training in their ISSPs’ description of their ongoing education and training related to information security.
Additionally, NFA’s proposed changes will expressly require members to notify NFA if they experience any cybersecurity incidents, and mandate approval of an ISSP by a member’s chief executive officer, other senior level officer with primary oversight for information system security (e.g., chief information security officer or chief technology officer), or other senior official who is a principal of the member and “has authority to supervise the [m]ember’s execution of its ISSP.”
In its proposed revised guidance, NFA indicated it will publish information on cybersecurity best practices and standard setting organizations that may be consulted for cybersecurity information in NFA’s ISSP Frequently Asked Questions that will be updated from time to time. (Click here to access NFA’s current FAQs.) Such information is currently available in NFA’s cybersecurity guidance itself.
The effective date for the revised guidance has not been determined. NFA generally establishes an appropriate effective date after it has received the CFTC's approval and develops a member education program, if necessary.
Unrelatedly, the CFTC proposed to amend its requirements that most registrants provide annual privacy notices to customers under all circumstances. The CFTC proposed that an annual notice not be required provided nonpublic personal information is provided to nonaffiliated persons only under certain enumerated circumstances and the firm has not changed its personal information policies and practices since its last notice. If a firm subsequently changes its policies and practices, it would have to provide a written notice to customers as prescribed by the Commission. The CFTC will accept comments on its proposal for 60 days following its publication in the Federal Register.
Revised: December 18, 2018 to clarify the effective date.
Compliance Weeds: CFTC registrants and NFA members have express obligations to ensure the security of their information systems and customers’ personal information. Among other things, most CFTC registrants are required to maintain policies and procedures to protect customer records and information (click hereto access CFTC Rule 160.30) and a written identity theft program (click here to access CFTC Rule 162.30(d)), while all NFA members must maintain a written information systems security program. SEC registrants have similar obligations. (Click here for background in the Compliance Weeds associated with the article “Broker-Dealer Resolves SEC Charges That Inadequate Cybersecurity Procedures Led to Cyber Intrusion, Compromising Customer Personal Information” in the September 30, 2018 edition of Bridging the Week.)
However, it appears regulators are increasingly not hesitant to file an enforcement action under a general failure to supervise theory when there is a cybersecurity breach if they feel that adequate policies and procedures reasonably designed to prevent and/or respond to a breach did not exist, and/or customer information or funds were or may have been compromised.
Within the last 15 months, the CFTC resolved an enforcement against Tillage Commodities, LLC, a CFTC-registered commodity pool operator, with failure to supervise for purportedly not monitoring and detecting unauthorized wire transfers processed by the administrator of a fund it operated. (Click here for details in the article “Two Commodity Pool Operators Charged by CFTC with Failure to Supervise” in the October 1, 2017 edition of Bridging the Week.) The CFTC also settled an enforcement action against AMP Global Clearing LLC, a CFTC-registered futures commission merchant, for its alleged failure to supervise a third party’s implementation of “critical” provisions of its information system security program. (Click here for details in the article “CFTC Says Futures Brokerage Firm’s Failure to Supervise Led to Unauthorized Cyber Attack” in the February 18, 2018 edition of Between Bridges.)
The beginning of each new year is as good an opportunity as any for financial services firms to review their ISSPs, other programs to protect customer confidential personal information, and relevant training.
Unrelatedly, the Chicago Mercantile Exchange resolved a disciplinary action against Hana Financial Investment for not cooperating with an exchange investigation into the trading activities of its customers. The firm agreed to pay a penalty of US $425,000 to settle this matter. Previously, Hana was subject to a summary access denial order by the exchange as a result of its noncooperation as well as its apparent netting of customer positions among independently owned and controlled accounts within omnibus accounts at “several” CME Group clearing members.(Click here for details in the article “CME Group Summarily Suspends Foreign Broker’s Access to All Its Markets for Not Cooperating Fully With Its Investigations and Purported Position Misreporting” in the June 3, 2018 edition of Bridging the Week.)
Separately, JoErik Financial Pte Ltd agreed to pay a fine of US $30,000 and disgorge profits in excess of US $20,000, while Jimmy Ng Kian Bin consented to a sanction of US $30,000 and a three-month all CME Group exchanges access suspension to settle spoofing allegations on the CME. Brian Soldano acceded to remit a fine of US $15,000 and a nine-week IFUS access suspension to settle spoofing charges on IFUS. Three persons – Xiaobao Huang, Mihir Salla and Ge Shuai – were ordered to pay fines from US $45,000 to US $60,000 and permanently barred from trading access to all CME Group exchanges for engaging in disruptive trading practices on the New York Mercantile Exchange and/or Commodity Exchange, Inc. while using another person’s Tag 50 identification. Apparently none of the individuals participated in the exchanges’ disciplinary process.
In other legal developments involving cryptoassets:
My View: FinCEN’s and the federal banking regulators’ hedging regarding the potential exposure of banks when exploring new technologies to comply with their BSA/AML obligations materially undercuts their encouragement to experiment with such new technologies.
For further information:
Being Smarter Than Your Counterparties Is Not Manipulation Rules Judge in CFTC Enforcement Action:
CFTC Chairman Cautions UK and EU to Lay Groundwork Now for No Clearinghouse Disruptions If Potential Hard Brexit:
Congressmen Propose Laws Mandating CFTC Study How to Prevent Virtual Currency Manipulation and Promote US Competitiveness in Blockchain Technology:
Exempt CTAs and CPOs Reminded of Annual Affirmation Obligation by NFA:
FinCEN and Five Federal Banking Regulators Encourage BSA/AML Innovative Approaches:
Lawsuit Filed Over Recent Bitcoin Cash Hard Fork:
NFA Proposes Guidance Amendments to Enhance Cybersecurity:
NYDFS Authorizes NY Commercial Bank for Blockchain Payment Application:
Trading Firm Sanctioned by IFUS for Not Adequately Testing Semi-Automated Trading System Before Rollout:
UNCIA Energy LP – Series I:
Jimmy Ng Kian Bin:
Hana Financial Investment:
JoErik Financial Pte. Ltd.:
SEC Kicks Bitcoin Fund Consideration Down the Road:
The information in this article is for informational purposes only and is derived from sources believed to be reliable as of December 8, 2018. 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.