ACTIONS TO IMPLEMENT DODD-FRANK

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1 In This Issue: ACTIONS TO IMPLEMENT DODD-FRANK... 1 OTHER CFTC REGULATORY ACTIONS... 4 CFTC AND CRIMINAL ENFORCEMENT ACTIONS... 6 NOTEWORTHY LITIGATION DEVELOPMENTS... 8 CME GROUP REGULATORY DEVELOPMENTS CME GROUP ENFORCEMENT ACTIONS NFA REGULATORY DEVELOPMENTS NFA ENFORCEMENT ACTIONS ACTIONS TO IMPLEMENT DODD-FRANK Congress Amends Swaps Push-Out Provision The Dodd-Frank Act contained a provision that prohibits federal assistance (including FDIC insurance) to any insured depository institution that is a swap dealer with respect to certain swap activities. In practical terms, this provision would have required large banks to push out those swap activities to a separate affiliate that is not Under the original Dodd-Frank legislation, banks were permitted to engage in certain derivatives transactions, such as swaps based on interest rates and currencies, but were required to push out other types of derivatives transactions such as credit default swaps, commodity swaps, and equity swaps. The amendment allows banks to covered by FDIC insurance. In December, engage in all types of derivatives transactions Congress amended this provision (over the objection of Senator Elizabeth Warren and others) except for structured finance swaps that are based on asset-backed securities. as part of the appropriations bill needed to fund the federal government. President Obama signed the bill into law on December 16, Revised Margin Rules for Uncleared Swaps Proposed Schiff Hardin Practice Carl A. Royal Managing Editor Paul E. Dengel Practice Group Leader Stacie R. Hartman Deputy Practice Group Leader Geoffrey H. Coll Jack P. Drogin Jacob L. Kahn Kenneth W. McCracken Michael L. Meyer Victoria Pool Christine A. Schleppegrell Michael K. Wolensky John S. Worden Elyse K. Yang On October 3, 2014, the CFTC published proposed rules in the Federal Register to establish minimum initial and variation margin requirements for uncleared swaps entered into by swap dealers and major swap participants (MSPs). The CFTC proposal is substantially similar to the proposal recently promulgated by five federal banking regulators. The CFTC s rules will apply to firms that are not overseen by the banking regulators. Notably, the CFTC proposal would not require non-financial end users to post margin for uncleared swaps. Because such entities generally use swaps to hedge commercial risks, the CFTC believes that they pose less risk of default than financial entities. (In January 2015, Congress adopted an amendment to the Dodd- Frank Act to provide an exception for nonfinancial companies from the requirement to post margin on uncleared swaps.) When margin is required to be posted, the CFTC proposal would require the initial margin collateral to be held in segregated accounts at an independent custodian. Rehypothecation of the margin collateral would be prohibited. The CFTC requested comments on all aspects of its proposed rules, including how they should apply to cross-border transactions in which one or both counterparties are non-u.s. persons. The closing date for comments was December 2, As of December 3, over 200 comments had been received. In a related development, the CFTC Division of Swap Dealer and Intermediary Oversight issued an interpretation on October 31, 2014 regarding certain notification requirements with respect to the posting of margin for uncleared swaps. Under the CFTC s rules, a swap dealer or MSP must provide annual notification to each counterparty of its right to require segregation of initial margin. The interpretation clarifies that

2 the notification is not applicable if no initial margin is required to be posted by the counterparty. It also provides that a swap dealer or MSP may, under certain conditions, rely on negative consent to satisfy its obligations to receive from its counterparty (a) confirmation that the counterparty received the annual notification and (b) the counterparty s election to require or not require segregation. Application of Dodd-Frank to Cross-Border Transactions In general, Dodd-Frank applies to cross-border swap transactions only when the transactions have a direct and significant connection with U.S. activities or effect on U.S. commerce. The CFTC in 2013 approved interpretive guidance describing how the CFTC will apply Dodd-Frank regulations to cross-border transactions. In addition, the CFTC staff in Staff Advisory No took the position that a transaction between a non-u.s. swap dealer and a foreign client is subject to the CFTC s swap rules if the swap is arranged, negotiated, or executed by personnel or agents of the non-u.s. swap dealer who are located in the United States. The position taken in the Staff Advisory is controversial, and it has never been enforced by the CFTC. The CFTC has issued a series of no-action letters that extended the date when non-u.s. swap dealers would be required to comply with it. The most recent no-action letter was issued on November 14, 2014, and it extends the compliance date until September 30, CFTC s Cross-Border Guidance Survives Industry Lawsuit Three industry associations the Securities Industry and Financial Markets Association, the International Swaps and Derivatives Association, and the Institute of International Bankers (collectively, the Associations) filed a lawsuit in federal court in the District of Columbia challenging the CFTC s interpretive guidance regarding cross-border swap transactions. Procedurally, the Associations argued that the CFTC failed to comply with the Administrative Procedure Act (APA) notice and comment requirements. The court rejected that argument because the CFTC guidance was non-binding and thus not subject to the APA requirements. Substantively, the Associations argued that the CFTC exceeded its authority under Dodd-Frank to regulate non-u.s. swap dealers. The court disagreed and granted, in part, the CFTC s motion to dismiss, while remanding select rules to the agency to assess the costs and benefits of the extraterritorial application of those rules. The court allowed the rules to remain in effect during the CFTC s consideration of costs and benefits. Relief Extended for Inter-Affiliate Swaps The CFTC s rules that require mandatory clearing for certain swaps contain an exemption for swaps between affiliated entities, provided that certain conditions are met. One of the conditions requires that swaps between one of the affiliated entities and an unaffiliated counterparty be cleared. However, it is impractical to meet that condition when the counterparty is not located in the United States because most foreign jurisdictions have not yet implemented a mandatory clearing requirement for swaps. Accordingly, the CFTC has issued no-action relief to allow affiliated entities to rely on this exemption even when their swaps with foreign counterparties are not cleared. In a recent no-action letter dated November 7, 2014, the CFTC extended the expiration date for such relief from December 31, 2014 until December 31, Mandatory Trading Requirement for Swaps in Package Transactions Dodd-Frank requires that all swap transactions subject to mandatory clearing must be executed either on a designated contract market (DCM) or a swap execution facility (SEF), except where no DCM or SEF makes the swap available to trade. In early 2014, the CFTC certified that certain interest rate swaps and certain credit default index swaps were available to trade. As a result of the CFTC s certification, bilateral, over-the-counter transactions in those swaps are unlawful, unless an exception (such as the end-user exception) is available. Application of the mandatory trading requirement is more complicated for transactions in swaps that are combined with transactions in other financial instruments and executed as a single packaged trade. If at least one of the components of a packaged trade is a swap that is subject to the mandatory 2

3 trading requirement, the CFTC has taken the position that the entire package must be executed on an exchange or a SEF. However, in recognition of the fact that the exchanges and SEFs are not prepared operationally to trade certain of such package transactions, the CFTC has issued no-action relief in this area. In a no-action letter dated November 10, 2014, the CFTC granted relief from the mandatory trading requirement for the swap components of the following types of package transactions until the dates specified below: For packaged trades in which at least one swap component is subject to mandatory trading and the other components are either (a) CFTCregulated swaps not subject to mandatory clearing, (b) swaps not subject to exclusive CFTC jurisdiction, or (c) non-swap instruments (with certain exclusions), the requirement will become effective on February 15, For packaged trades in which at least one swap component is subject to mandatory trading and the other components are agency mortgagebacked securities, the requirement will become effective on May 15, For packaged trades in which at least one swap component is subject to mandatory trading and the other components are futures contracts, the requirement will become effective on November 14, For packaged trades in which at least one swap component is subject to mandatory trading and the other components are bonds newly issued and sold in the primary market, the requirement will become effective on February 12, CFTC Expands Hedging Choices for Government-Owned Utilities On September 17, 2014, the CFTC approved an amendment to the de minimis exception from the definition of swap dealer with respect to certain swaps entered into with governmentowned utilities. Under rules adopted in 2012, a firm is excluded from the definition of swap dealer if its level of swap dealing activity during the preceding 12-month period did not exceed a specified threshold known as the de minimis threshold. The general de minimis threshold was initially set at $8 billion of aggregate notional amount of swaps so that only firms dealing with large numbers of swaps would be required to register. However, the original CFTC rule also provided a separate and much lower de minimis threshold of $25 million for swaps entered into with special entities. Government-owned gas and electric utilities are deemed to be special entities under the CFTC s rule. This threshold had the effect of limiting the types of firms willing to enter into swaps with special entities only to large banks that were registered as swap dealers. Under the amended rule, swaps with utility special entities would count against the larger $8 billion general de minimis threshold rather than the smaller $25 million threshold, provided that the swaps are used for hedging a utility special entity s risk in connection with (i) the generation, production, purchase, or sale of natural gas or electric energy; (ii) the supply of natural gas or electric energy to a utility special entity; (iii) the delivery of natural gas or electric energy service to customers of a utility special entity; (iv) the fuel supply for the facilities or operations of a utility special entity; (v) compliance with an electric system reliability obligation; or (vi) compliance with an energy, energy efficiency, conservation, renewable energy, or environmental statute or regulation applicable to a utility special entity. CFTC Clarifies Test for Forwards with Volumetric Optionality In November 2014, the CFTC and SEC proposed a clarification of their previously issued interpretation and seven-part test concerning the exclusion of forward contracts with embedded volumetric optionality from the definition of swap. The interpretation was designed to guide the commercial energy market on how to maintain the forward nature of their contracts (actual delivery of the commodity) while allowing the flexibility needed by energy companies and utilities to exercise the option to add or remove volume to the underlying quantity of product to be delivered in response to market demand. The most important clarification proposed was to the seventh element of the test, which would be restated as follows: The embedded volumetric optionality is primarily intended, at the time that the parties enter into the agreement, contract, or transaction, to address physical factors or regulatory requirements that reasonably influence demand for, or supply 3

4 of, the nonfinancial commodity. This new language is meant to clarify that (1) the embedded volumetric optionality must be intended at the time of execution of the agreement, contract or transaction to address any physical factors or regulatory requirements that reasonably influence supply or demand; (2) the parties must have some degree of influence or control over physical or regulatory requirement factors affecting supply and demand as opposed to these factors being completely outside their control ; (3) the physical factors should be construed broadly to include any fact or circumstance that would reasonably influence supply or demand issues including environmental factors, operational considerations, and broader social forces such as demographics or geopolitics; and (4) electric demand response agreements would meet the regulatory requirement within the meaning of the seventh element (emphasis added to reflect the fundamental aspects of the modifications in the interpretive proposal). The public comment period ended on December 22, 2014, and a decision by the CFTC is expected in early OTHER CFTC REGULATORY ACTIONS CFTC Extends Comment Period for Proposed Position Limit Rules In 2013, the CFTC proposed new rules for position limits that would establish spot-month and all-months position limits for futures, options, and economically equivalent swaps on 28 physical commodities. The CFTC also published proposed amendments to its rules for determining when positions held by two or more related entities should be aggregated for the purpose of complying with the position limit rules. These issues were discussed at a meeting of the CFTC s Agricultural Advisory Committee on December 9, In order to permit commenters to address issues raised at that meeting, the time for commenting on the proposed rules was extended until January 22, CFTC s Residual Interest Requirement Becomes Effective In 2013, the CFTC approved new rules designed to enhance protections for customers. One such rule requires futures commission merchants (FCMs) to hold sufficient proprietary funds (a residual interest ) in customer segregated accounts and Part 30 secured accounts to reasonably ensure that the firms are properly segregated and secured at all times, and to cover margin deficiencies in customers trading accounts. Effective as of November 14, 2014, the residual interest rule requires FCMs to use their own funds to cover any individual customer margin deficits outstanding as of 6:00 p.m. (Eastern Time) on the business day following the trade date. The original CFTC rule required its staff to conduct a study to address cost-related questions, to solicit public comments, and to conduct a public roundtable. The CFTC then would consider whether to modify its schedule for phasing in the residual interest requirement. If the CFTC took no action, the time by which customer margin deficits are to be calculated would be accelerated automatically, effective as of December 31, 2018, from 6:00 p.m. on the business day following the trade date to the time of the first daily settlement, which typically occurs in the early morning on the business day following the trade date. However, at a meeting on November 3, 2014, the CFTC Commissioners voted to propose an amendment to the CFTC rule that would remove the automatic acceleration of the time for calculating customer margin deficits if no action is taken before December 31, If this amendment is adopted, the current time for making that calculation would remain in effect unless and until the CFTC determines to change it through a separate rulemaking. Comments on this proposed amendment are due on or before January 13, CFTC Provides Guidance and Grants Extension of Time for CCO Annual Reports The Division of Swap Dealer and Intermediary Oversight issued CFTC Staff Advisory No on December 22, The Advisory provides guidance to FCMs and swap dealers on what should be included in the annual compliance report to be prepared by the firm s chief compliance officer (CCO). Although the Advisory does not mandate a specific organization or approach, it does suggest a number of best practices for CCO annual reports. One suggestion is that the report include a summary chart that (1) identifies the applicable regulatory requirements, (2) identifies which of the firm s written policies and procedures (WPPs) address each such requirement, (3) contains a cross-reference to the specific section of the 4

5 relevant WPP, (4) assesses the effectiveness of the WPP in meeting the regulatory requirements, and (5) describes the method used by the firm to assess the WPP s effectiveness. Concurrently with issuing the Advisory, the CFTC staff also granted an extension of time to certain firms for filing the CCO annual report. The CFTC s rules ordinarily require the CCO annual report to be filed within 60 days of the firm s fiscal year end. However, for FCMs and swap dealers that have a fiscal year ending on or before January 31, 2015, the report can be filed within 90 days of the firm s fiscal year end. In addition, if a firm is unable to submit its report within that time period, it will be allowed another 30 days to do so, provided that the firm notifies the CFTC of any material non-compliance events no later than the end of the original 90-day period. CFTC Proposes Amendments to Relax CTA Recordkeeping Requirements A CFTC rule requires commodity trading advisors (CTAs) who are members of a DCM or a SEF to record all oral communications related to transactions in commodity interests (i.e., futures, options on futures, and swaps) and related cash and forward transactions. On November 3, 2014, the CFTC Commissioners voted to propose an amendment to that rule to eliminate the requirement for CTAs to record such oral communications. The proposed amendment also would eliminate, for all market participants, a requirement that records of oral and written communications must be linked to particular commodity interest transactions. The comment period for the proposed amendment ends on January 13, In addition, the CFTC staff has granted no-action relief in this area that will expire on the earlier of (i) final CFTC action on the proposed amendment or (ii) December 31, Family Offices Obtain No-Action Relief The CFTC staff in 2012 granted no-action relief to family offices from the requirement to register as a commodity pool operator (CPO), provided that certain conditions were met. In a letter dated November 5, 2014, the CFTC staff expanded the no-action relief so that family offices are not required to register as a CTA either, again provided that certain conditions are met. It should be noted that this relief is not selfexecuting. To qualify for the relief, a family office must file a claim with the CFTC to elect the relief. The claim will be effective upon filing if it is accurate and complete. CFTC Eases Advertising Ban for Hedge Funds Congress in 2012 enacted the so-called JOBS Act, which was intended to spur job growth by easing regulation of investments in privately-held companies, including hedge funds. In 2013, the SEC adopted rule amendments to permit an issuer of securities to engage in general solicitation or advertising in offering its securities to purchasers who are accredited investors. However, certain exemptions from the CPO registration requirements in CFTC rules applied only if interests in the commodity pool were not marketed to the general public. The CFTC staff granted exemptive relief to permit general solicitation or advertising of commodity pool interests under specified conditions comparable to those contained in the SEC s rules. A CPO seeking this exemptive relief must file a notice with the CFTC. The relief will be effective upon filing, provided that the notice is materially complete and accurate. CPOs Permitted to Delegate Certain Responsibilities In a no-action letter dated October 15, 2014, the CFTC staff provided a streamlined process by which the CPO of a commodity pool (the Delegating CPO) can delegate the responsibility to register as a commodity pool s CPO to another entity (the Designated CPO). Among other conditions, the Delegating CPO must execute a legally binding document in which it delegates all of its investment management authority with respect to the commodity pool to the Designated CPO. This relief is self-executing, without the need to submit any filing to the CFTC. 5

6 CFTC AND CRIMINAL ENFORCEMENT ACTIONS Criminal Indictment in Spoofing Case The CFTC first used its new authority under amended Section 4c(a)(5) of the Commodity Exchange Act (CEA) regarding disruptive trading in a July 2013 settlement with Panther Energy Trading LLC and Michael J. Coscia. The CFTC order found that, from August 2011 through October 2011, the respondents engaged in the disruptive practice of spoofing in 18 futures contracts traded on four exchanges. In particular, it found that the traders had utilized an algorithmic trading program designed to place bids and offers and then quickly cancel them before execution. In October 2014, the U.S. Attorney in Chicago sought and received an indictment against Coscia for the alleged spoofing conduct. The indictment is for six counts of spoofing and six counts of fraud and could bring a total of 25 years in prison. In December 2014, the defense filed a motion to dismiss the criminal charges arguing that the spoofing statute is unconstitutionally vague and that there was no notice that this type of conduct was unlawful. While the new authority under the CEA defines spoofing, there is considerable disagreement on the scope of the definition as there is no generally accepted meaning of the term in the futures markets. The case is still pending. The fact that criminal charges have been brought indicates that disruptive trading, along with manipulation and fraud, is likely to be a focus of future enforcement actions. CFTC Settles Attempted Manipulation with Spoofing before it was Disruptive Trading The CFTC settled an attempted manipulation case involving conduct similar to spoofing in the wheat futures market against Eric Moncada and two proprietary trading firms, BES Capital LLC (BES) and Serdika LLC (Serdika), in October The alleged violative conduct occurred in 2009, before Section 4c(a)(5) was amended to make spoofing a specific offense under the CEA. After the CFTC was granted summary judgment against Moncada on charges of fictitious sales and non-competitive transactions, the parties settled the attempted manipulation charges for a $1.56 million civil monetary penalty and permanent trading and registration bans. Per the consent order, Moncada engaged in three trading tactics as part of his scheme: (1) manually placing and immediately cancelling numerous large-lot orders with the intent that the orders not be filled, but instead to create a misleading impression of liquidity in the market (aka spoofing ); (2) placing these largelot orders in a manner to avoid being filled by the market; and (3) placing small-lot orders on the opposite side of the market with the intent of taking advantage of any price movements caused by his large-lot orders. The court had denied summary judgment on the issue of attempted manipulation, but noted its [agreement] with the CFTC that the most compelling inference one might draw from the trading records is that Moncada was indeed trying to manipulate the market. The significance of this case lies not only in the apparent absence of any direct evidence (e.g. s, instant messages, testimony, etc.) that Moncada acted with specific intent for the orders not to be filled, but also in the court s apparent willingness to agree with the CFTC that sufficient evidence of the defendants intent may be derived from the defendants pattern of trading alone. MF Global Holdings Settles with CFTC On December 23, 2014, the CFTC obtained a consent order from the federal court against MF Global Holdings Ltd. for $1.212 billion in restitution (or the amount necessary to ensure that customer claims of its FCM subsidiary, MF Global Inc., are paid in full) plus $100 million in civil monetary penalties. The CFTC s amended complaint charged that MF Global Holdings controlled MF Global Inc. s operations and was responsible for its unlawful use of customer funds, its failure to notify the CFTC immediately when it knew or should have known of the deficiencies in its customer accounts, the filing of false statements in reports with the CFTC regarding the customer accounts, and the use of customer funds for impermissible investments in securities. The restitution obligation of MF Global Holdings is joint and several with the restitution obligation of MF Global Inc., which was ordered to pay the same amount. The civil monetary penalties are to be paid to the CFTC only after the claims of customers and certain other creditors have been satisfied. Related CFTC litigation against former MF Global Chief Executive Jon Corzine and former Assistant Treasurer Edith O Brien is still ongoing. 6

7 Alleged Manipulation of Benchmark Cases Settled LIBOR cases The CFTC filed and settled three actions in 2014 on charges of manipulation, attempted manipulation, and false reporting of market information relating to LIBOR and other interest rate benchmarks. The CFTC imposed more than $580 million in civil monetary penalties and required internal controls improvements to strengthen the benchmark setting process within the banks - Lloyds Banking Group, PLC ($105 million penalty), RP Martin Holdings Limited and Martin Brokers (UK) Ltd. ($1.2 million penalty), and Coöperatieve Centrale Raiffeisen- Boerenleenbank B.A. (Rabobank) ($475 million penalty). The orders stated that the banks traders coordinated their trading and price submissions with traders at other banks in an attempt to manipulate, and to successfully manipulate, LIBOR rates. FX Fix cases The CFTC filed and settled actions in 2014 against five banks that allegedly attempted to manipulate the global foreign exchange (FX) benchmark rates to benefit their own trading positions or those of certain traders. The five banks were Royal Bank of Scotland plc (RBS), Cibibank, N.A., JPMorgan Chase Bank, N.A., UBS AG, and HSBC Bank plc. The RBS order described conduct (which is typical of the conduct found in all five cases) in which RBS traders coordinated their trading with traders at other banks to manipulate FX benchmark rates, including the World Markets/Reuters Closing Spot Rates (WM/R Rates), which is one of the most widely referenced rates in the United States and globally. The WM/R Rates are calculated multiple times a day, including at 4 p.m. London time, based on actual trades, bids, and offers extracted from a certain electronic trading system during a one-minute window called the fix period. The traders used private electronic chat rooms to plan their attempts to manipulate by disclosing confidential information on positions, altering positions to accommodate their collective interests, and agreeing to trading strategies. CFTC Settles Oil Manipulation Case The CFTC settled a manipulation case in August 2014 involving crude oil futures against Parnon Energy Inc., Arcadia Petroleum Ltd., Arcadia Energy (Suisse) SA, Nicholas Wildgoose and James Dyer. The complaint alleged that the defendants took advantage of a tight physical market by executing a trading strategy designed to affect NYMEX crude oil futures contract spreads by knowingly amassing a dominant and controlling position in physical West Texas Intermediate (WTI) crude oil. Specifically, the CFTC alleged that the defendants held the physical position until after futures expiry with the intent to affect NYMEX crude oil spreads and then sold the physical position during the cash window at a loss. The complaint further alleged the defendants hoped to profit by buying WTI futures spreads prior to widening the spreads through their manipulation and by then selling WTI futures spreads prior to dumping their physical WTI crude oil position. The defendants agreed to pay a $13 million civil monetary penalty, limit their physical market trading, and maintain records and audio recordings for three years, among other undertakings. CFTC Files Complaint to Enforce Settlement Order In another action involving oil futures, the CFTC filed a complaint to enforce a settlement order regarding an attempted manipulation of crude oil futures at NYMEX and for violations of position limits against Daniel Shak and his former company, SHK Management LLC. The order had found that on certain trading days, respondents were banging the close in the WTI oil futures contracts. In November 2013, the respondents had agreed to a $400,000 civil monetary penalty, trading bans and restrictions, including prohibiting Shak from trading futures contracts in any market during the closing period for a period of two years. On September 30, 2014, the CFTC filed a federal suit charging Shak with violating the terms of the settlement order. The CFTC alleged that Shak violated the prior settlement order by trading two June 2014 gold futures contracts during the closing period. The complaint specifically alleged that Shak failed to report this violation to the CFTC or his FCM until being confronted by the FCM. The CFTC is seeking additional civil monetary penalties against Shak for this alleged violation of the prior order. This action indicates that the CFTC will closely monitor compliance of its settlement orders and take quick action to enforce them. 7

8 Prearranged or Fictitious Trading Still in CFTC Crosshairs The Commission filed and settled charges against several respondents for prearranged trades that constituted fictitious sales. In re FirstRand Bank, Ltd. and In re Absa Bank, Ltd. Two separate CFTC orders charged FirstRand Bank and Absa Bank with prearranged noncompetitive trades from June 2009 to August The orders alleged that the respondents prearranged noncompetitive corn and soybean futures trades on the CBOT through telephone conversations where they agreed upon the product, quantity, price, direction, and timing of those trades before entering them into the market as close to the same time as possible. Both FirstRand Bank and Absa Bank agreed to pay a $150,000 civil monetary penalty to settle the charges, with the CFTC noting their cooperation with the investigation. In re Fan Zhang The CFTC issued an order settling charges of prearranged noncompetitive trades with Fan Zhang. Specifically, the Commission order found that Zhang transferred trading profits between two separate accounts by intentionally placing buy and sell orders for the same price, volume, and expiration month in CME s Las Vegas Housing Market and Cash-Settled Cheese futures contracts and CBOT s Ethanol futures contract. The order alleged that one of the accounts was held in the name of FZIC, LLC, which was an investment club 50 percent owned by Zhang, and the other account was held in the name of Zhang s mother, which realized a $200,000 profit. Zhang agreed to pay a $250,000 civil monetary penalty. CFTC Sues Defense Attorney for Aiding and Abetting Client s Fraud On September 9, 2014, the CFTC filed a complaint in federal court in Florida alleging that Florida-based attorney Jay Bruce Grossman willfully aided and abetted multiple clients in their operation of illegal and fraudulent precious metals schemes. The complaint alleged that Grossman s clients claimed to sell physical precious metals such as gold, silver, platinum, palladium, and copper to retail customers on a leveraged or financed basis, when in fact they never owned or possessed any of the physical metals. The CFTC had previously obtained judgments against Grossman s clients in connection with these activities. The complaint alleged that Grossman was wellversed in the inner workings of his clients business and was aware that they did not sell or store physical metals. Further, the complaint alleged Grossman aided his clients in their schemes by his actions that led customers to believe the clients claims were legitimate and complied with the law. The complaint alleged that Grossman drafted fraudulent customer forms and made material misrepresentations regarding the true nature of his clients business to customers and to both federal courts and the CFTC. While the CFTC has, on rare occasions, brought legal actions against defense attorneys for being involved in a fraud, this action marks the first use of the CFTC s new authority under Section 6(c)(1) of the CEA and CFTC Regulation The CFTC charged Grossman with aiding and abetting his clients intentional or reckless use or employment of a manipulative or deceptive device in connection with false representations in connection with the sale of a commodity in interstate commerce. NOTEWORTHY LITIGATION DEVELOPMENTS Two Private Lawsuits Against U.S. Bank Stemming from Peregrine Fraud Move Forward In the fall of 2014, the federal court in Chicago allowed two purported class actions against U.S. Bank to proceed arising from Peregrine Financial Group s misappropriation of more than $215 million from customer segregated funds held in accounts at U.S. Bank. One case was brought by a class of individual customers, and the other by Fintec Group, Inc., on behalf of a class of brokers. Although the court dismissed certain claims in the customer class action lawsuit, it allowed the case to proceed because it found that a fiduciary relationship arose between the customers and U.S. Bank when the customers deposited funds in a customer segregated account held at U.S. Bank. As a result, the claims of fraud by omission and breach of fiduciary duty will proceed to discovery. 8

9 In the second lawsuit, Fintec, an introducing broker, brought a class action on behalf of brokers who placed customer orders or deposited securities with Peregrine, but never received commissions and/or return of security deposits. Fintec brought two claims under the CEA: (1) that U.S. Bank was liable for aiding and abetting Peregrine s violations of the CEA; and (2) that U.S. Bank was directly liable to Fintec for U.S. Bank s violations of the CEA. The court allowed Fintec to proceed on both CEA claims against U.S. Bank because it found that the claims satisfied the plain language of the CEA s limited private right of action. In allowing the CEA aiding and abetting claims to proceed, the court determined that U.S. Bank had facts before it that should have led U.S. Bank at least to inquire as to whether Peregrine s use of the funds in the customer account was proper. After finding the allegations of U.S. Bank s knowledge to be sufficient based on the conscious avoidance doctrine, the court allowed the CEA claims to proceed to discovery, with intent issues to be resolved at summary judgment or trial. In related litigation, the CFTC and U.S. Bank settled the action brought by the CFTC alleging that U.S. Bank improperly had used Peregrine customer funds as security for guaranties of loans made to Peregrine and its owner. The terms of the settlement are confidential. Sentinel Bankruptcy Trustee Loses Case Against Bank of New York Mellon In the latest development in a case stemming from the failure and bankruptcy of Sentinel Management Group, a U.S. district court in Chicago rejected the arguments made by the Sentinel bankruptcy trustee that Bank of New York Mellon (BNYM) should be required to return collateral that it had held to secure loans made to Sentinel. Before its failure, Sentinel used hundreds of millions of dollars in customer assets to secure overnight loans at BNYM used to fund large repo transactions. Sentinel did this even though FCMs are required to keep customers funds in segregated accounts and not allow the funds to be used for other purposes. When Sentinel failed during the credit crisis of 2007, the bank was in a secured position, but Sentinel s customers lost millions. In an appeal from an earlier ruling in this case, the Court of Appeals for the Seventh Circuit remanded the case to the district court to consider two issues: (1) what BNYM knew before Sentinel s collapse and (2) whether BNYM s failure to investigate Sentinel rose to the level of negligence, recklessness, or deliberate indifference. The district court concluded that the evidence did not show that BNYM knew or believed that Sentinel engaged in misconduct before it collapsed and that the doctrine of equitable subordination should not be applied because BNYM s inquiry, although possibly negligent, was insufficient to establish inequitable conduct. The court also noted that Sentinel s misconduct had not been detected by either NFA or the firm s auditors. Trading Firms are Victims of Trade Secret Theft Trader Steals Source Code from Trading Firm. In the fall of 2014, a federal grand jury in Chicago indicted a futures trader, David Newman, who now faces three counts of theft of trade secrets for stealing files containing computer source code and programs from his employer. Newman allegedly downloaded more than 400,000 files onto a flash drive, and quit his job after working at his firm since Newman then started his own business, WH Trading, which claims to specialize in next generation trading tools. Each of the three counts carries a maximum penalty of 10 years in prison. Citadel Employees Steal Proprietary Software. An ex-citadel LLC employee pled guilty to stealing proprietary trading strategy and algorithms from two companies. Prior to working at Citadel, Mr. Yihao Pu downloaded source code and other files to his personal computer and resigned the following day. Next, Mr. Pu joined Citadel, where he again copied proprietary software. In an effort to hide his actions when confronted, Mr. Pu erased data from his computer and threw computer equipment in a sanitary canal. A colleague of Mr. Pu, Mr. Sahil Uppal, pled guilty to obstructing justice by assisting Mr. Pu. Offshore Conduct Insufficient to Sustain Private Suit Under CEA The Second Circuit Court of Appeals upheld the district court s dismissal of an action brought under the CEA by a Russian citizen residing in Russia involving investment contracts that were signed in Russia. The Second Circuit found that the CEA creates a private right of action for persons anywhere in the world who transact business in the United States, and does not 9

10 open our courts to people who choose to do business elsewhere. In reaching its conclusion the court emphasized that (i) plaintiff s investment deal was signed, sealed, and delivered in Russia, where the parties resided; (ii) the sales materials were written in Russian; and (iii) plaintiff s investment contracts were signed in Russia. FCM Found to Have Liquidated Customer Account in Bad Faith In a CFTC reparations proceeding decided in October 2014, the judgment officer ruled that Gain Capital Group (Gain), a registered FCM and retail forex dealer, wrongfully liquidated a customer s account in order to cover a margin deficit. The customer did not dispute that his account was undermargined, but he argued that Gain should have liquidated just one USD/ CHF forex contract (rather than all four contracts) to cover the deficit. Gain asserted that its account agreement with the customer gave it discretion to liquidate any or all open positions in the account if the account had a margin deficit. The judgment officer agreed with the customer that liquidating one contract would have been sufficient, and he ruled that Gain acted in bad faith by liquidating additional contracts and thus violated its duty to the customer under Section 4d(a)(2) of the CEA. This decision appears to be in conflict with other cases upholding an FCM s right to take action under its account agreement at its discretion to protect itself against the risk of a customer failing to meet his margin obligations. CME GROUP REGULATORY DEVELOPMENTS CME Adopts New Rule 575 (Disruptive Practices Prohibited) To expand upon the Dodd-Frank Act amendments to Section 4c(a) of the CEA, the CME adopted a new Rule 575, effective September 15, 2014, to prohibit multiple types of disruptive practices. Whereas Section 4c(a) of the CEA prohibits three specific disruptive practices (1) violating bids or offers, (2) intentional or reckless disregard for the orderly execution of transactions during the closing period, and (3) spoofing CME Rule 575 is much broader. First, it requires that all orders be entered for the purpose of executing bona fide transactions and that all non-actionable messages (e.g., requests for quotes, the creation of User Defined Spreads, and administrative messages) be entered in good faith for legitimate purposes. Second, it identifies the following broad list of prohibited practices: 1. No person shall enter or cause to be entered an order with the intent, at the time of order entry, to cancel the order before execution or to modify the order to avoid execution. 2. No person shall enter or cause to be entered an actionable or non-actionable message or messages with intent to mislead other market participants. 3. No person shall enter or cause to be entered an actionable or non-actionable message or messages with intent to overload, delay, or disrupt the systems of the Exchange or other market participants. 4. No person shall enter or cause to be entered an actionable or non-actionable message with intent to disrupt, or with reckless disregard for the adverse impact on, the orderly conduct of trading or the fair execution of transactions. Rule 575 applies to open outcry as well as electronic trading, and during all market states (including pre-open periods). To accompany Rule 575, the CME issued Market Regulation Advisory Notice on August 29, 2014 (the Advisory Notice). Included in the Advisory Notice are 22 Frequently Asked Questions and answers, including a lengthy list of factors that CME may consider in deciding whether a participant s conduct violates Rule 575, and definitions of the more nebulous phrases used in Rule 575 (e.g., orderly conduct of trading or the fair execution of transactions ). Also included in the Advisory Notice is a non-exhaustive list of nine examples of conduct prohibited under Rule 575. The examples are quite specific, and should prove useful to firms and individuals trading on CME. Although the CFTC did not adopt CME s Advisory Notice, and was not required to do so, it did make minimal edits before the guidance was re-released on September 15, Thus, it is arguable that, by failing to change anything else in the market regulation advisory, the CFTC has at least implicitly approved its content. Other exchanges have adopted similar rules. ICE Futures U.S. and ICE Futures Canada adopted rules, effective on January 14, 2015, that prohibit certain specified disruptive trading practices. 10

11 CME Market Regulation Advisory Notice on Rule 534 (Wash Trades Prohibited) On December 17, 2014, CME released a revised Market Regulation Advisory Notice (the December 17 MRAN) on Rule 534 Wash Trades Prohibited. The revised notice, which became effective on January 2, 2015, made several changes to the prior advisory notice on Rule 534. First, the December 17 MRAN amended the answer to Frequently Asked Question No. 8. This question asks whether market participants may freshen position dates without violating the prohibition on wash trades. CME revised the answer to this question to reflect its decision, effective January 2, 2015, to eliminate the existing prohibition on freshening positions in Live Cattle Futures. permitted if the trades and the parties meet the conditions set forth in the notice (which have not changed). On December 24, 2014, just one week after the December 17 MRAN was released, CME issued a revised version of the MRAN that restored the original answer to Question No. 9 and therefore apparently reversed the change in policy reflected in the December 17 MRAN. It thus appears that block trades between accounts with common beneficial ownership (including 100% ownership in common) are permissible under Rule 534 so long as all of the conditions set forth in the answer to Question No. 9 are met. The CME is expected to revisit this issue early in Second, the December 17 MRAN amended the answer to Question No. 9. This question asks whether block trades between different accounts with the same or common beneficial ownership violate the wash trading prohibition. Previously, the answer to this question stated that block trades between accounts with common beneficial ownership were permitted under certain circumstances. As revised, however, the notice stated that block trades between accounts with the same beneficial ownership (i.e., both accounts are 100% owned by the same owners) are strictly prohibited. Where accounts share common beneficial ownership (i.e., less than 100% ownership in common), block trades between them are Finally, the December 17 MRAN amended the answer to Question No. 11. This question asks about the circumstances under which trading opposite a party s own order on an exchange s electronic platform will violate the prohibition on wash trades in Rule 534. Although CME s Globex system previously incorporated Self-Match Prevention (SMP) functionality, CME rolled out new SMP enhancements effective December 21, 2014 and January 11, 2015 that, among other things, allow customers to dictate whether their resting or aggressing orders should be cancelled in the event of a selfmatch. The revised notice reflects the new aspects of CME s SMP functionality. CME Sanctions Member for Spoofing Activity CME GROUP ENFORCEMENT ACTIONS Effective November 28, 2014, CME member Igor Oystacher settled a CME Group disciplinary proceeding based on alleged spoofing activity in July 2011 on COMEX and NYMEX. According to the notice of disciplinary action, the COMEX and NYMEX Business Conduct Committee (BCC) panels found that Oystacher had entered bids and offers in multiple futures contracts without the intent to actually complete any transactions. Oystacher then cancelled the bids and offers before execution. Similarly, the panel found that Oystacher had placed iceberg orders at or near the best bid/offer on one side of the market, and had subsequently placed large orders on the opposite side of the market. Oystacher then cancelled the large orders once trading had stopped on his iceberg order, often less than a second after they were entered. Due to the size of his non-iceberg orders and the limited time during which they were exposed to the market, the panel concluded that Oystacher had entered them with the intent to cancel them before execution i.e., to spoof. Oystacher agreed to pay a total fine of $150,000 for his conduct on both exchanges, and to serve a one-month bar from membership and access privileges. System Failures Result in Firms Being Fined by CME Group Exchanges A number of firms were fined by the CME Group related to breakdowns in their automated trading systems: Credit Suisse Securities (USA) LLC settled a CME Group disciplinary proceeding for alleged violations 11

12 of Rule 432. A panel of the CME s BCC found that Credit Suisse s automated trading system (ATS) rapidly entered and executed buy and sell orders of different sizes in several futures contracts on January 31, The entries and executions, which were triggered by an erroneously quoted stock price, caused higher than usual volume in the contracts at issue. The BCC Panel found that Credit Suisse lacked sufficient controls to prevent erroneous thirdparty data from impacting the operation of its ATS. Credit Suisse agreed to settle the matter for $150,000 without admitting or denying the allegations. 303 Proprietary Trading, LLC (303 Trading) agreed to pay a fine of $75,000 related to excessive messages sent by its proprietary trading system during two seconds on May 8, According to CME, 303 Trading s system failure resulted in over 27,000 resend messages, CME s initiation of a port closure, and the failure of a Globex gateway. CME claimed that 303 Trading s failure was caused by its failure to conduct sufficient testing or simulation on its ATS to ensure its suitability for sending administrative messages on Globex. Traditum Group LLC was fined $35,000 because of the failure of an ATS purchased from a third-party vendor that malfunctioned and caused 3,540 one-lot round turn transactions in December Canadian dollar futures contracts during approximately two minutes on November 10, 2011, which represented a significant volume spike in the futures contract. NFA REGULATORY DEVELOPMENTS NFA Bans Credit Card Funding of Futures and Forex Accounts Effective on January 31, 2015, futures and foreign exchange (forex) accounts may not be funded by a credit card or any other electronic method tied to a credit card (e.g., Paypal). NFA members may continue to fund futures and forex accounts through electronic means, for example, through direct withdrawals from a bank account with which a debit card is associated. However, before an intermediary accepts customer funds, it must be able to identify whether the funds are coming from a financial institution or a credit card. The NFA instituted this new rule to protect customers, because credit cards inherently allow easy access to borrowed money. NFA President Dan Roth explained that individuals should use only risk capital to fund their forex and futures accounts, noting that the forex and futures markets are both high-risk and volatile. Annual Affirmation Requirement for Entities Currently Operating Under an Exemption or Exclusion from CPO or CTA Registration On December 3, 2014, the NFA published a notice in which it provided guidance on the annual affirmation requirement for entities currently operating under an exemption or exclusion from CPO or CTA registration, including answering a few FAQs. The CFTC requires any person that claims an exemption or exclusion from CPO registration under CFTC Regulations 4.5, 4.13(a)(1), 4.13(a)(2), 4.13(a)(3), 4.13(a)(5), or an exemption from CTA registration under Regulation 4.14(a) (8), annually to affirm the applicable notice of exemption or exclusion within 60 days of the calendar year end (which is March 2, 2015 for this affirmation cycle). Failure to affirm any of the above exemptions or exclusions by March 2, 2015 will be deemed to be a request to withdraw the exemption or exclusion and, therefore, result in the automatic withdrawal of the exemption or exclusion on March 2, In the FAQs, the notice provides information on how to update NFA records regarding inactive pools and what to do if an exemption or exclusion no longer applies. It also explains that new exemptions filed during the affirmation period do not need to be affirmed until the end of calendar year Affirmation or withdrawal of an exemption or exclusion will be published on NFA s BASIC system. 12