Effective Trading Compliance MFA Compliance 2015

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1 MFA Compliance 2015 Brian T. Daly Partner Schulte Roth & Zabel LLP May 5, 2015

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3 Introduction Mike Hughes Managing Director, Head of Fund Services, Institutional Cash & Securities Services Deutsche Bank Daniel Kochav Partner and Chief Operating Officer Tenor Capital Management Brian Daly Partner Schulte Roth & Zabel 3

4 Insider Trading United States v. Newman On Dec. 10, 2014, the Second Circuit held that: In order to sustain insider trading charges against a remote tippee who trades on material nonpublic information: The government must prove that the remote tippee knew that the tipper breached his fiduciary duties by Disclosing confidential corporate information to a tippee In exchange for a personal benefit. The court further held that personal benefit: May not be inferred by the mere fact of friendship between the tipper and tippee Must represent at least a potential gain of a pecuniary or similarly valuable nature 4

5 Insider Trading Continuing Issues Advisory committees and value-added investors Forensic testing Expert networks Conferences and broker-arranged one-on-ones 5

6 Insider Trading Training [R]ecent cases make it clear that investment advisory firms must provide training and guidance to ensure that, when employees come into possession of inside information, the firm has adequate and effective control processes in place to prevent illegal insider trading. Commissioner Luis A. Aguilar, Doing the Right Thing: Compliance That Works for Investors (April 18, 2013) The Annual Compliance Meeting? Non-traditional approaches Use of technology in training Use of small groups? How focused? How small? Documenting attendance Marketing benefits from training 6

7 Spoofing Section 747 of the Dodd-Frank Act Incorporated anti-spoofing concepts into the Commodity Exchange Act Section 4c(a) of the CEA ( Disruptive Practices ): Unlawful to engage in any trading [that] (C) is, is of the character of, or is commonly known to the trade as, spoofing (bidding or offering with the intent to cancel the bid or offer before execution) 2013 CFTC Interpretive Guidance and Policy Statement Intent-based When distinguishing between legitimate trading and spoofing, CFTC intends to evaluate the relevant facts and circumstances Four nonexclusive examples of spoofing behavior: Submitting or cancelling bids or offers to overload the quotation system of a registered entity Submitting or cancelling bids or offers to delay another person s execution of trades Submitting or cancelling multiple bids or offers to create an appearance of false market depth Submitting or canceling bids or offers with intent to create artificial price movements The Commission also does not intend to apply the spoofing provision as covering authorized pretrade communications CME Group Rule 575 ( Disruptive Practices Prohibited ) Effectively declares spoofing to be a type of disruptive order entry and trading practice that is abusive to the orderly conduct of trading or the fair execution of transactions 7

8 Spoofing Cases (CFTC) Moncada (2014) Alleged manipulation of the wheat futures markets, characterized as the wholesale entering and cancelling of orders without the intent to actually fill the orders $1,560,000 civil monetary penalty 8

9 Spoofing Cases (DOJ/CEA) Coscia (2014 and ongoing) DOJ indictment against Michael Coscia Follow-on action (i.e., a parallel proceeding ) building on civil and SRO enforcement actions against Coscia and his former trading firm by the CFTC, the CME Group and the U.K. Financial Conduct Authority Allegations: In August 2011, Coscia began a high-frequency trading strategy in which he entered large-volume orders that he intended to immediately cancel before they could be filled by other traders. Strategy designed: To create a false impression regarding the number of contracts available in the market To induce other market participants to react to the deceptive market information Strategy moved the markets in a direction favorable to Coscia, Enabling him to purchase contracts at prices lower than, or sell contracts at prices higher than, the prices available in the market before he entered and canceled the large-volume orders Repeated this strategy in the opposite direction, Enabling him to immediately obtain a profit by buying futures contracts at a lower price than he paid for them or by selling contracts at a higher price than he paid for them 9

10 Spoofing Cases (DOJ/CEA) Coscia (continued ) Coscia s arguments to dismiss: The anti-spoofing provisions are unconstitutionally vague Spoofing has no settled meaning Court rejects these arguments N.D. Ill. (Leinenweber) [I]ntent to cancel is not impermissibly vague 10

11 Spoofing Cases (SEC) SEC Activity (a/k/a layering ) Visionary Trading LLC $1.9-million settlement Hold Brothers (2012) $4-million settlement CCO liability 11

12 Spoofing Cases (Flash Crash) CFTC and DOJ charge Nav Sarao Futures Limited PLC and Navinder Singh Sarao with unlawfully manipulating, attempting to manipulate and spoofing. General Allegations Defendants have engaged in a massive effort to manipulate the price of S&P 500 E-Mini futures Utilized a variety of exceptionally large aggressive, and persistent spoofing tactics. In June 2009, Defendants modified a commonly used off-the-shelf trading platform to automatically and simultaneously layer four to six exceptionally large sell orders into the visible E-Mini S&P central limit order book (the Layering Algorithm ), with each sell order one price level from the other As the E-Mini S&P futures price moved, the Layering Algorithm allegedly modified the price of the sell orders to ensure that they remained at least three or four price levels from the best asking price; thus, remaining visible to other traders, but staying safely away from the best asking price. Eventually, the vast majority of the Layering Algorithm orders were canceled without resulting in any transactions. According to the Complaint, between April 2010 and April 2015, Defendants utilized the Layering Algorithm on over 400 trading days. Defendants cycled the Layering Algorithm on and off several times during a typical trading day to create large imbalances and traded in a manner designed to profit from this temporary artificial volatility. Profits of over $40 million from E-mini S&P trading. Flash Crash Allegations (May 6, 2010): Defendants utilized the Layering Algorithm continuously, for over two hours, immediately prior to the precipitous drop in the E-Mini S&P price, applying close to $200 million worth of persistent downward pressure on the E-Mini S&P price. Defendants manipulative activities contributed to an extreme E-Mini S&P order book imbalance that contributed to market conditions that led to the Flash Crash. The Complaint further alleges that Defendants engaged in a variety of other manual spoofing techniques whereby Defendants allegedly would place and quickly cancel large orders with no intention of the orders resulting in transactions. At times, according to the Complaint, this manual spoofing was used to exacerbate the price impact of the Layering Algorithm. 12

13 Spoofing Effective Surveillance? Order book review Not just fills Cancellation reviews criteria How soon is too soon? Code reviews? 13

14 Rule 105 Rule 105 Prohibits any person from purchasing securities: From an underwriter or broker-dealer In a firm commitment equity offering If that person had previously sold short the security that is now the subject of the offering during the Rule 105 restricted period (i.e., the shorter of the period: Beginning five business days before the pricing of the offered securities and ending at pricing; or Beginning at the initial filing of the registration statement and ending at pricing) Unless an exception applies. 14

15 Common Rule 105 Issues and Questions Identifying Covered Offerings By its terms, Rule 105 applies only to firm commitment and underwritten offerings. In a firm commitment offering, one or more investment banks agree to act as underwriters and are thereby obligated to purchase a fixed number of securities from the issuer, although they intend to immediately resell all or substantially all of them to the public. However, there is no definition in the rule of what a firm commitment underwritten offering is for Rule 105 purposes. Managers should consider the totality of the specific facts and circumstances of an offering, including situations such as underwriters taking responsibility for specified numbers of shares and the timing and wording of the underwriting agreement. 15

16 Common Rule 105 Issues and Questions Identifying Covered Offerings By its terms, Rule 105 applies only to firm commitment and underwritten offerings of equity securities. Rule 105 is not applicable to offerings of non-convertible debt, options or other derivatives. However, convertible debt is deemed to be an equity security. Managers, however, should consult with legal counsel before participating in an offering of convertible debt if the manager has shorted the related common stock within the Rule 105 restricted period. While options and other derivatives are not considered equity securities, the SEC s anti-fraud and anti-manipulation provisions of the federal securities laws still apply. 16

17 Common Rule 105 Issues and Questions Isolating the Restricted Period A business day under Rule 105: A 24-hour period determined with reference to the principal market for the securities to be distributed, which includes a complete trading session for the market in question If the offering prices today (Tuesday, May 5) at 5:00 pm The restricted period began at 5:00 pm Tuesday, April 28 Count backwards from today at 5:00 pm and be sure each 24-hour period includes an entire trading session 17

18 Common Rule 105 Issues and Questions Exceptions Bona fide purchases A purchase of, or purchases that total to, a number of securities at least equal to the number of securities shorted during the restricted period NOT just getting back to flat ; During regular trading hours; That is (are) reported; and That is (are) effected after all short sales that occurred during the Rule 105 restricted period and no later than the business day prior to the day of pricing 18

19 Common Rule 105 Issues and Questions Exceptions Separate Accounts Indicia of separateness: Separate and distinct investment and trading strategies and objectives Personnel do not coordinate trading among or between the accounts Information barriers Separate profit and loss statements No allocation of securities between or among accounts Persons with higher-level oversight or managerial responsibility do not have authority to execute or pre-approve trades 19