Developments in Securities Regulation, Corporate Governance, Capital Markets, M&A and Other Topics of Interest. MORE

On July 22, 2013, regulators from the United States Commodity Futures Trading Commission (CFTC) and the British Financial Conduct Authority (FCA) fined high frequency trader Michael Coscia (and his firm Panther Energy Trading) for engaging in spoofing transactions for the purpose of layering bids or offers. As we have previously written, a “spoof” occurs when a trader bids or offers with the intent—and intent is the key to a spoof—to cancel the bid or offer prior to execution. In this case, Coscia spoofed by placing algorithmic bids or offers on Globex, which he intended to, and did, cancel prior to execution.

Coscia spoofed to engage in layering. The FCA described layering as placing small orders and then larger orders to create a false impression of liquidity. Then the larger orders were cancelled, which induced the market to trade the small orders. The FCA said:

Coscia’s layering strategy typically meant placing a small order, which he intended to trade on one side of the order book, followed by a series of large orders on the opposite side of the order book, which were not genuine. These larger orders—typically 20 times the average size of orders placed by other market participants—were designed to create a false and misleading impression of liquidity for those products, and induce the market to trade the smaller orders. The execution of the small order would then trigger the immediate cancellation of the large orders. This pattern would then be repeated on the opposite side of the order book in order to make a profit from price movements generated by the trading strategy. FCA fines US based oil trader US $903K for market manipulation Financial Conduct Authority Press Release at note 3.

The CFTC described the spoofing and layering strategy in the context of trading Light Sweet Crude Oil futures. The strategy was to use large orders—which were intended to be cancelled—to induce the purchase of a small sell order at a profit (and at the expense of other high frequency traders or traders using algorithmic and/or automated systems.)

  1. The algorithm placed a relatively small order on one side of the market at or near the best price being offered to buy or sell, in this instance a sell order for 17 contracts at a price of $85.29 per barrel, which was a lower price than the contracts then being offered by other market participants.
  2. Within a fraction of a second, Coscia entered orders to buy a relatively larger number of Light Sweet Crude Oil futures contracts at progressively higher prices: the first bid at $85.26, the second bid at $85.27, and the third bid at $85.28. The prices of these bids were higher than the contracts then being bid by other market participants.
  3. Coscia placed the large buy orders to give the market the impression that there was significant buying interest, which suggested that prices would soon rise, raising the likelihood that other market participants would buy the 17 lots he was then offering to sell.
  4. But Coscia entered into the large buy orders with the intent that these buy orders be cancelled before the orders were actually executed.
  5.  This strategy sought to capture an immediate profit from selling the 17 lots. As the CFTC concluded, “if the program successfully filled the small 17-lot sell order, the large buy orders were immediately cancelled and the algorithm was designed to promptly operate in reverse. That is, the algorithm would then enter a small buy order in conjunction with relatively large sell orders at progressively lower prices, which sell orders Coscia intended to cancel prior to execution.” In the Matter of: Panther Energy Trading LLC and Michael J. Coscia, CFTC Docket No. 13-26, Order Instituting Proceedings Pursuant to Section 6(c) and (d) of Commodity Exchange Act, as Amended, Making Findings and Imposing Remedial Sanctions, July 22, 2013, at 3.

For this activity, the FCA fined Coscia and Panther approximately $900,000, the first time the FCA has taken enforcement action against a high frequency trader. The CFTC fined them $1.4 million, ordered disgorgement of $1.4 million and prohibited them from trading on any registered entity for one year.

The one-year trading ban could have been higher. Referring to high frequency traders as “cheetahs” because of their speed, CFTC Commissioner Bart Chilton argued for a much more significant trading ban to “protect markets and consumers, and to act as a sufficient deterrent to other would-be wrongdoers.” Concurring Statement of Commissioner Bart Chilton in the Matter of Panther Energy Trading LLC and Michael J. Coscia at 1. He said, “[i]n today’s cheetah trading world where identities can be cloaked behind technology, a year trading ban might simply be a nice sabbatical for a cheetah trader to work on some new algo[rithm] programs to unleash after the trading ban has expired.” Id.

 

The SEC recently issued proposals related to Regulation D which, among other things, require a Form D to be filed fifteen days before a general solicitation under Rule 506(c) can commence.  Two Congressmen recently sent a letter to SEC Chair Mary Jo White claiming the provision effectively violates the JOBS Act.  According to the letter “Proposed Rule 503 requires a fifteen day waiting period, after filing Form D, before allowing advertisements – this restriction appears to violate the law by imposing a fifteen day ban on general solicitation. Title II of the JOBS Act lifted the ban on general solicitation for Regulation D 506 offerings to accredited investors. As a result, the Form D pre-filing requirement effectively violates Title II of the JOBS Act.”

The letter also object to filing solicitation materials: “Additionally, the proposed Rule 510T will require that for the first two years during which the proposed rule is in place, issuers must provide the Commission with all advertisements by the date of first use. Problems clearly exist with the imposition of this same-day or virtually “real-time” compliance requirement on an enormous market of small issuers that, prior to public advertising, have already raised nearly one trillion dollars per year. To the extent the disclosure of advertisements Under Rule 510T supports analytical or market evaluation needs, samples of data should clearly suffice, yet the Commission seeks the entire population of advertising information on a same-day basis for two years – as a result, market analysis alone cannot realistically explain the imposition of this heavy burden.”

For more information on the topic, see JOBS Act and Other Securities Law Essentials for Growing Companies.

Check jobs-act-info.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

The CFPB filed a complaint in federal district court against a Utah-based mortgage company, Castle & Cooke Mortgage LLC, and two of its officers for illegally giving bonuses to loan officers who steered consumers into mortgages with higher interest rates.  The complaint alleges that Castle & Cooke, through the actions taken by its president, and a senior vice-president, violated the Federal Reserve Board’s Loan Originator Compensation Rule.

The CFPB alleges that the company violated the rule with its quarterly bonus program, which paid more than 150 Castle & Cooke loan officers greater bonus compensation when they persuaded consumers to take on more expensive loans. The average quarterly bonus ranged from $6,100 to $8,700. By contrast, those loan officers who did not charge consumers higher interest rates did not receive quarterly bonuses. The CFPB estimates that more than 1,100 illegal quarterly bonuses were paid and that tens of thousands of customers may have been upsold since April 2011. By tying bonuses to the interest rate of the loans in this manner, the CFPB alleges that Castle & Cooke was in direct violation of the law.

The CFPB also believes Castle & Cooke violated laws that require companies to retain their compliance records for a certain period of time. Creditors are required to retain evidence of compliance with the rule. The complaint alleges that Castle & Cooke did not record what portion of each loan officer’s quarterly bonus was attributable to a particular loan and did not reference its quarterly bonus program in each loan originator’s compensation agreement, in violation of federal consumer financial law.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

GAO has completed a report mandated by the Dodd-Frank Act on the accredited investor standard.  The report examines market participants’ views on

  • the existing criteria for accredited investor status and
  • alternative criteria.

To address these objectives, GAO conducted a literature review, examined relevant data, and interviewed domestic and foreign regulators and industry representatives to identify alternative criteria. GAO also conducted structured interviews of 27 market participants (including broker-dealers, investment advisers, attorneys, and accredited investors).

GAO recommended the SEC should consider alternative criteria for the accredited investor standard. For example, participants with whom GAO spoke identified adding liquid investments and use of a registered adviser as alternative criteria. The SEC agreed with GAO’s recommendation.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

We have prepared a comprehensive set of materials addressing private placements and new changes being implemented by the JOBS Act.  The materials discuss:

  • Offerings without general solicitation
  • Offerings with general solicitation
  • Liability arising from private placements
  • Issues arising from the use of finders
  • Common mistakes made by issuers
  • Common mistakes made by lawyers

Check jobs-act-info.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

The SEC suggests in its final rules eliminating the ban on general solicitation that law firms may be in a position to verify accredited investor status for issuers conducting Rule 506(c) offerings.  We have begun to receive inquiries about whether we will do so.  We haven’t decided if we will, but I imagine someone will ask our securities group what this would look like.

So here are my thoughts:

[Issuer name and address]

Dear [    ]:

[Client name] (“Client”) has asked us to provide [name of issuer] with this letter to assist your determination of whether Client is an “accredited investor” as defined in Rule 501(a) promulgated by the  United Sated Securities and Exchange Commission under the Securities Act of 1933.  We draw your attention to the fact that the determination of whether a person is an accredited investor is a factual question and therefore not susceptible to a legal opinion.  Accordingly, this letter is not a legal opinion and we make no representations about whether Client is an accredited investor or whether this letter is sufficient for your purposes.

In connection with this letter, we have examined the original or photostatic copies of the following documents:

  1. Joint tax returns for the years [    ] and [     ] (each, a “Tax Year”) filed by Client and [his/her] spouse on Form 1040 (the “Tax Returns”), accompanied by a certificate of the Client that that the copies of the Tax Returns provided were true, correct and complete, filed with the appropriate office of the Internal Revenue Service, prepared in full compliance with applicable law and governmental regulations and have not been amended.
  2. A certificate executed by Client and [his/her] spouse, attached hereto, addressed to the Issuer and us, stating such persons have a reasonable expectation of joint income in the current year in excess of $300,000.

Based solely on the foregoing, we hereby advise you that in each Tax Year line 22 of the Tax Returns indicates income in excess of $300,000.

We have not conducted any other investigation or inquiries of Client, and have not determined whether the Tax Returns were accurately prepared, agree with source documents, were properly filed or otherwise.

By rendering this letter, we do not intend to waive any attorney-client privilege.  This letter is limited to the matters set forth herein and speaks only as of the date hereof.  Nothing may be inferred or implied beyond the matters expressly contained herein. This letter may be relied upon by you and only in connection with an offering under Rule 506(c) and only for 30 days from the date of this letter.  This letter may not be used, quoted from, referred to or relied upon by you or by any other person for any other purpose, nor may copies be delivered to any other person, without in each instance our express prior written consent.  We assume no obligation to update this letter.

 

Very truly yours,

 

[Law Firm]

Check jobs-act-info.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

The United States District Court for the District of Columbia has upheld the SEC’s conflict minerals rule in National Association of Manufacturers et al v. Securities and Exchange Commission.  Points noted by the Court include:

  • There is no statutory support for plaintiffs’ argument that the SEC was required to evaluate whether the conflict minerals rule would actually achieve the social benefits Congress envisioned.
  • The conflict minerals rules differ significantly from other SEC rules that have been invalidated.  Those cases involved rules or regulations that were proposed and adopted by the SEC of its own accord, with the Commission having independently perceived a problem within its purview and having exercised its own judgment to craft a rule or regulation aimed at that problem.
  • While it may be true that the adoption of some type of de minimis approach could also have been a reasonable, alternative option, this does not render the SEC’s contrary determination arbitrary or unreasonable.
  • Congress did not directly speak to the precise circumstances triggering disclosure obligations (and, by implication, due diligence and reporting requirements) in enacting Section 1502 of the Dodd-Frank Act.
  • The conflicts mineral rule and statute does not violate the first amendment because  it compels “burdensome and stigmatizing speech.”  The disclosure scheme directly and materially advances Congress’s interest in promoting peace and security in and around the DRC.  There is a reasonable fit between the government’s goals and the means chosen to advance those goals.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

On July 15, 2013, the CFTC sought comments on a proposed CME Group Market Regulation Advisory (Advisory) providing guidance and answering frequently asked questions on wash trades.  As the name implies, a wash trade is (i) a transaction or series of transactions that produce a wash result, i.e., no bona fide market position, market risk or price competition and (ii) the parties intended that wash result.  The Advisory states that “[i]ntent may be inferred from evidence of prearrangement or from evidence that the orders or trade(s) were structured, entered or executed in a manner that produces that the part(ies) knew, or reasonably should have known, would produce a wash result.” Advisory Answer to Q1.

Throughout the Advisory, this issue of intent flows through the answers to various questions.  For example, the advisory addresses wash trades when the buying and selling of accounts with common beneficial ownership — initiated by independent decision makers — coincidentally cross in the market. In response, the Advisory cautions that such trades will be subject to scrutiny, the outcome of which will depend on whether the trades were prearranged and whether either party “intended for their order to trade against the other’s order.” The Advisory states:

Buy and sell orders for accounts with common beneficial ownership that are independently initiated for legitimate and separate business purposes by independent decision makers and which coincidentally cross with each other in the competitive market are not considered wash trades provided that the trade was not prearranged and neither party had knowledge of the other’s order or otherwise intended for their order to trade against the other’s order. Market participants should be aware, however, that trades between accounts with common beneficial ownership may draw additional regulatory scrutiny and should be prepared to demonstrate that such trades are bona fide.  Id. Answer to Q 10.

Similarly, the issue of intent arises when different proprietary traders within the same firm match against each other, either through their own trading practices or the use of an algorithm.  The Advisory states that “[p]rovided that the respective orders of each independent trader are entered in good faith for the purpose of executing bona fide transactions, are entered without prearrangement, and are entered without the knowledge of the other trader’s order, then such trades shall not be considered to violate the prohibition on wash trades.” Id. Answer to Q 12.  Further, “orders generated by algorithms operated and controlled by fully independent traders in different trading groups that unintentionally and coincidentally match with each other will not be considered to be wash trades provided that the orders are initiated in good faith for the purpose of executing bona fide transactions, that the algorithms operate independently of one another, and that the respective trading groups do not have knowledge of one another’s orders.  Id.

But in addition to showing this lack of intent, the Advisory stresses throughout that market participants must be proactive — by employing functionality — to prevent wash trades.  For example, while the “unintentional and incidental matching of buy and sell orders entered by an individual trader on the electronic platform” generally will not be considered a wash trade,  Id. Answer to Q 11,  “if such self-matching occurs on more than an incidental basis in the context of the trader’s activity or in the context of the particular market’s activity, such trades may be deemed to violate the prohibition on wash trades. It is recommended that individual traders who frequently enter orders on opposing sides of the market that have a tendency to self-match on more than an incidental basis employ functionality that will minimize the potential for their buy and sell orders to match with each other.”  In addition, where multiple algorithms are operated or controlled by the same individual or team of individuals may generate self match events on more than an incidental basis, the Advisory recommends that individual or team “employ functionality to minimize or eliminate such occurrences.” Id. Answer to Q 13.

The CME Group introduced Self-Match Prevention (“SMP”) functionality on CME Globex in June 2013.  While the SMP functionality is not mandatory, the Advisory reminds market participants that wash trades are illegal and “[f]irms and market participants should carefully review their operations and the guidance in this Advisory Notice, and, where appropriate, take steps necessary to minimize the potential for such trades either through the useof SMP functionality or by alternative means.” Id.  Answer to Q 16.

Comments to the CFTC on the Advisory are due August 14, 2013.

The Fifth Circuit has held in Asadi v. G.E. Energy (USA), LLC that a whistleblower must provide information to the SEC in order to be protected by the Dodd-Frank anti-retaliation provisions.  The reasoning is pretty simple.  That’s the way the statute defines the term “whistleblower.”  The Court went as far as to reject the definition of “whistleblower” in the SEC’s rules.

We understand this to be the first appellate court decision on the issue.  As we have noted, district courts have ruled differently on the issue.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

The Government Accountability Office, or GAO, has published a study highlighting some issues with conflict-free minerals sourcing.  Agency and industry officials as well as representatives from international organizations and nongovernmental organizations stated that adoption of the SEC conflicts minerals rule as well as stakeholder-developed initiatives—which include the development of guidance documents, audit protocols, and in-region sourcing of conflict minerals—can support companies’ efforts to conduct due diligence and to identify and responsibly source conflict minerals. For example, officials GAO interviewed explained that the Conflict-Free Smelter Program enables suppliers to source conflict minerals from smelters (companies that refine the ore of the conflict minerals into metals) that have been certified by an independent third-party auditor as obtaining their minerals from sources that did not benefit armed groups.

GAO also cited:

  • Constraining factors such as lack of security, lack of infrastructure, and lack of capacity in the DRC that could affect the ability to expand on efforts to achieve conflict-free sourcing of minerals from eastern DRC and thereby potentially contribute to armed groups’ benefiting from the conflict minerals trade.
  • Officials GAO interviewed noted that there is a lack of infrastructure in place that would enable companies to set up or expand operations in the DRC. Limited transportation and poor roads in eastern DRC also make it difficult to get to mine sites.
  • Remoteness of mines also makes it difficult for DRC officials to validate mines and ensure that the mines have not been compromised by illegal armed groups.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.