The CFTC Settles Another Spoofing Case

On July 26, 2017, the U.S. Commodity Futures Trading Commission (“CFTC”) issued an order finding that Simon Posen engaged in the “disruptive practice of ‘spoofing’ (bidding or offering with the intent to cancel the bid or offer before execution).” The CFTC’s findings, which spanned more than three years, beginning at least in December of 2011, indicated that Posen, based in New York City, had traded from his home, using his own account, in violation of Section 4c(a)(5)(C) of the Commodity Exchange Act (7 U.S.C. § 6c(a)(5)(C)), which explicitly outlaws spoofing.

The CFTC found Posen placed thousands of orders in gold, silver, copper, and crude oil futures contracts with the intent to cancel them before execution. These orders were placed so as to move the market prices so that smaller orders, which he would also place on the other side of the market, would be filled.

The CFTC permanently banned Posen from trading in any market regulated by the CFTC and from applying for registration or claiming exemption from registration with the CFTC, ordered him to cease and desist from spoofing, and penalized him $635,000. Posen settled without admitting or denying any of the CFTC’s findings or conclusions. James McDonald, Director of the CFTC’s Division of Enforcement, made clear that spoofing prosecutions remain a priority for the CFTC and people, like Posen, “will face severe consequences.”

Under the new leadership at the CFTC — the future marches on —with a continuing aggressive emphasis on the investigation and civil prosecution of manipulative trading and in particular spoofing. The CME Group had initially investigated aspects of Posen’s trading on two occasions and ordered a $75,000 fine and five-week trading bar and subsequently, for other activity, ordered a $90,000 fine and four-week trading bar. Drinker Biddle will continue to monitor the CFTC’s and CME’s actions so as to provide continuing analysis and counseling for our clients.

The SEC Heightens Its Interest in Robo-Advisers

Over the last two weeks, the SEC has put robo-advisers on notice that they are on the staff’s radar. First, on February 23, 2017, the SEC’s Division of Investment Management, along with the SEC’s Office of Compliance, Inspections, and Examinations, issued a Guidance Update for robo-advisers. The term “robo-adviser” refers to registered automated investment advisers that provide investment advice that uses computer algorithms. Robo-advisers generally collect information about a client’s financial goals, income, assets, investment horizon, and risk tolerance by way of an online or electronic questionnaire. With limited human interaction, robo-advisers use this information to create and manage investment portfolios for clients. Robo-advisers are often more economical than traditional investment advisers. Robo-advisers, which began as an appeal to millennials, are now widely becoming popular with all age groups and types of investors.

The Guidance Update focused on in three unique areas of the investment relationship: (1) the substance and presentation of disclosures to clients about the robo-adviser and the investment advisory services it offers; (2) the obligation to obtain information from clients to support the robo-adviser’s duty to provide suitable advise; and (3) the adoption and implementation of effective compliance programs reasonable designed to address particular concerns relevant to providing automated advice.

This Guidance Update specifically encourages robo-advisers to keep clients well-informed with respect to their use of algorithms to manage client funds. Robo-advisers must be diligent in their disclosures to clients of the risks and limitations inherent in the use of algorithms to manage investments. For example, an algorithm may not address prolonged changes in market conditions and investors need to know that. The Guidance Update also reminds robo-advisers that because of the limited human interaction with the client, issues, like disclosures, would most likely be done online. As such, communications, including written disclosures, should be effective, not hidden or indecipherable. Finally, the Guidance Update highlighted that for robo-advisers, compliance with the Advisory Act of 1940 may require more written documentation than regular investment advisers must provide. For example, robo-advisers should consider documenting the development, testing, and backtesting of the algorithms, the process by which they collect client information, and the appropriate oversight of any third party that develops or owns the algorithm or software utilized by the robo-adviser.

In addition to the Guidance provided to robo-advisers, the SEC Office of Investor Education and Advocacy also issued an Investor Bulletin on the subject of robo-advisers to alert potential clients to specific areas when dealing with a robo-adviser would be different from a more traditional adviser. Such areas include (1) the minimized level of personal interaction a client would receive, e.g., do you ever speak to a human?; (2) the standard information a robo-adviser uses to formulate recommendations, e.g., are the robo-advisers asking all the pertinent questions in their questionnaires?; (3) the robo-adviser’s approach to investing, e.g., are the robo-advisers using pre-determined portfolios or can you customize your investments?; and (4) the fees and charges involved, e.g., could you be charged penalties or fees if you want to withdraw your investment?  Investors should consider using robo-advisers because of the economic advantages but must be aware of the differences inherent in this new 21st century version of the investment advisor.

The SEC requires robo-advisers to be registered and makes them subject to the same substantive and fiduciary obligations as traditional investment advisers. In addition to the Alert and the Guidance Update, the SEC staff also addressed robo-advisers at SEC Speaks on February 24, 2017. At the Office of Compliance Inspections and Examinations (“OCIE”) panel, the office’s senior leadership put the audience and industry on notice of OCIE’s “Electronic Investment Advice Initiative.” Specifically, OCIE advised that it will be dedicating staff and resources to prioritize examining robo-advisers for this SEC fiscal year. Due to OCIE applying a risk-based approach to its examination program, they will likely focus on robo-advisers with large platforms or business models that OCIE believes pose potential risks to investors. For robo-advisers to prepare, we recommend that firms review the February 23, 2017 Guidance Update and the Office of Investor Education and Advocacy Investor Bulletin described above to proactively plan to be in compliance with this guidance. This way, firms examined as part of the Electronic Investment Advice Initiative, can attempt to avoid significant deficiencies or enforcement referrals from OCIE’s increased scrutiny of robo-advisers.

Supreme Court Reaffirms Dirks and Tosses Prosecution a Win

In Salman v. United States, 580 U.S. __ (2016), the U.S. Supreme Court upheld Bassam Salman’s conviction, giving prosecutors a win on the first insider trading case to be heard by the Court in nearly two decades. The unanimous decision, written by Justice Samuel Alito, is short and to the point. The Court reaffirmed the continued validity of Dirks v. S.E.C., 463 U.S. 646 (1983), and determined that a tipper receives a personal benefit by providing insider information to a “trading relative or friend.”

In Dirks, the Court ruled that a tippee’s liability for trading on inside information hinges on whether the tipper breached a fiduciary duty by disclosing the information. The fiduciary duty is breached when the insider will personally benefit, directly or indirectly, from his disclosure. In Salman, the Supreme Court stated that the benefit did not have to be money, property, or something of tangible value, because “giving a gift of trading information is the same thing as trading by the tipper followed by a gift of the proceeds.”

This decision resolved a circuit split between the Ninth Circuit, which had affirmed Salman’s conviction, and the Second Circuit, which ruled in United States v. Newman, 773 F.3d 438 (2d Cir. 2014), that prosecutors had to prove that insiders received monetary or some sort of valuable benefit in exchange for disclosing information in order to convict the tippee who had used said information. The Supreme Court found that “[t]o the extent the Second Circuit held that the tipper must also receive something of a ‘pecuniary or similarly valuable nature’ in exchange for a gift to family or friends, Newman 773 F.3d at 452, we agree with the Ninth Circuit that this requirement is inconsistent with Dirks.” Yet, the Supreme Court seemed careful to imply that some portions of Newman remain good law, such as the requirement that the tippee knows the insider received a personal benefit from providing the inside information.

Despite, or perhaps because of the brevity of the opinion, questions still remain about what exactly is a benefit to the tipper. Clearly, familial connections or close friendships between the tipper and the tippee mean that prosecutors do not have to prove a specific pecuniary benefit occurred for the tipper, but would the same hold true if the tippee was a neighbor? Or, as the Second Circuit opined in Newman, an acquaintance from church or business school? The Supreme Court dodged these questions and more by deciding Salman narrowly on the facts, a model of judicial restraint in the wake of far ranging decisions like McDonell v. United States that essentially rewrote how prosecutors handle corruption cases.

Department of Justice Obtains Its Second Spoofing Conviction and Its Novel Cooperation Agreement.

On the heels of its successful prosecution of Michael Coscia for spoofing, the Department of Justice (“DOJ”) recently secured a guilty plea and cooperation agreement in another high-profile “spoofing” case. By way of background, spoofing is the illegal practice of placing trades on the bid or offer side of a market with the intent to cancel them before execution in order to manipulate prices for personal gain. On November 9, 2016, Londoner Navinder Singh Sarao pleaded guilty to two criminal charges after losing his battle against extradition from the UK.  Despite being charged with 22 counts, including wire fraud, commodities fraud, and spoofing, Mr. Sarao pleaded guilty to just two counts—one count of wire fraud, 18 U.S.C. § 1343 (which carries a maximum of 20 years’ imprisonment and a fine of $250,000) and one count of spoofing, 7 U.S.C. § 6c(a)(5)(c) and 13(a)(2) (which carries a maximum of 10 years’ imprisonment). He also acknowledged unlawful gains of at least $12,871,587.26 in trading profit as a result of his criminal actions and has agreed to forfeit that sum as part of his sentence. In addition, he has agreed to cooperate with the government, as discussed in more detail below. Although Mr. Sarao’s stated advisory sentencing guideline range is 78 to 97 months imprisonment, the DOJ  will very likely seek a downward departure pursuant to Guideline § 5K1.1 as a result of his cooperation.

Mr. Sarao pleaded guilty to the following scheme. From January 2009 until at least April 2014, Mr. Sarao fraudulently traded E-mini S&P 500 futures contracts (the “E-mini”) on the Chicago Mercantile Exchange (“CME”). During the relevant time period, Mr. Sarao placed thousands of orders to buy or sell futures contracts of the E-mini on one side of the market with the intent to not execute those orders at the times that he placed them. Thus, he intended to manipulate the impressions of supply and demand for E-minis so as to induce other market participants to react and either buy or sell E-mini futures in response to his deception. When the market reacted accordingly, Mr. Sarao would execute genuine orders to buy or sell E-Mini future contracts on the opposite side of the market so as to generate significant trading profits.

Mr. Sarao generated these spoof orders both manually and using automated programs.  Manually, he used two techniques. In the first technique, he would place large spoof orders (2,000-Lot Spoof Orders) that he did not intend to execute on the opposite side of the market from his genuine orders to buy or sell, thereby inflating volume and, in turn, creating artificially high or low prices to his advantage. Mr. Sarao used this technique approximately 802 times and made at least $1,884,537.50 in profit as a result. His second manual technique involved placing hundreds of resting spoof orders one or two levels of price from the best bids or offers currently available on the market. Mr. Sarao thereby created a false sense of supply or demand and would then trade genuine orders on the opposite side of the market to take advantage of the artificially inflated or deflated price.

Mr. Sarao also used automated programs to further his scheme. He utilized a “dynamic layering technique” that generated a block of typically five “sell” orders that would appear in unison at different sequential price points above the then-current E-mini sell price. As the current sell price moved, Mr. Sarao’s five “sell” orders moved in concert to remain the same distance above the sell price as they originally began, which thus reduced the chance that his orders would be executed. He used this technique to artificially create market activity approximately 3,653 times between 2009 and 2014 and made at least $9,667,258.22 in profit as a result of trading on the opposite side of the market. Mr. Sarao also utilized a second automatic technique known as the “Back of the Queue” Function. This technique added one unit to a particular designated order to increase its size when another order from a market participant was entered at the same size and price point as Mr. Sarao’s order, thereby ensuring that his orders were always more expensive, bigger, and behind all the other more attractive orders that were available so that it would not be executed or purchased. This artificially inflated the volume and, in turn, the interest on one side of the market. Mr. Sarao activated this function approximately 758 times and fraudulently made at least $1,319,791.54 in profit as a result. In addition to his fraudulent and manipulative schemes, Mr. Sarao made materially false statements and misrepresentations to the Commodities Futures Trading Commission (“CFTC”), CME, and regulatory officials in the UK.

These are a few points of interest regarding this guilty plea:

  • The U.S. Attorney’s Office for the Northern District of Illinois, home of the Securities and Commodities Fraud Section that obtained Michael Coscia’s guilty verdict, was acknowledged by “Main Justice” for its assistance with the case. The efforts of DOJ Main Justice, in coordination with the Northern District’s Securities and Commodities Fraud Section and the CFTC, indicate the high level of importance that the federal government places on pursuing criminal manipulative trading cases, such as Sarao and Coscia.
  • Under the original indictment, the DOJ accused Mr. Sarao of reaping at least $40 million in profits as a result of these schemes. While the plea agreement required him to forfeit more than $12,000,000, on November 17, 2016, the CFTC announced in its parallel case that Mr. Sarao settled with the CFTC and agreed, among other relief, to pay $25,743,174.52 in monetary penalties and to submit to a permanent trading ban.
  • Despite having fought extradition for nearly 18 months, after he pleaded guilty, Mr. Sarao was released on bail and was permitted to return to London with an 11 p.m. to 4 a.m. curfew to continue his cooperation with the government. Such cooperation must be extraordinary for the DOJ to agree to his return to a foreign country immediately after it had obtained extradition and the guilty plea.

With its second successful prosecution of spoofing since it was formally criminalized by statute with the 2010 Dodd-Frank Act, the DOJ is clearly making deterrence of such techniques one of its primary goals. Of course it is yet to be seen what type of cooperation Mr. Sarao can provide, but his lawyer told the court at his guilty plea hearing that despite his severe Asperger’s Syndrome, he had extraordinary abilities of pattern recognition. Such statements indicate that Mr. Sarao may provide technical cooperation to the DOJ in multiple, ongoing investigations, as opposed to the more usual cooperation of informing on others. With Mr. Sarao’s conviction and the Coscia appeal pending, DOJ’s ongoing efforts in this space are currently not public; however, Mr. Sarao’s cooperation may accelerate these pending investigations. With the DOJ’s and CFTC’s strong commitments to cracking down on spoofing and manipulative trading, we can expect that more DOJ and CFTC cases will be forthcoming.

The criminal case is United States v. Sarao, Case No. 15-cr-00075 (N.D. Ill.). The civil case is United States Commodity Futures Trading Commission v. Sarao, Case No. 15-cv-03398 (N.D. Ill.).

The Supreme Court Appears Poised to Reaffirm Dirks v. SEC and Maintain Current Insider Trading Rules

For the first time in two decades, the Supreme Court heard oral argument in a case that could change the landscape for the government’s pursuit of insider trading violations. In Salman v. United States (Dkt. No. 15-628), the Court reviewed the government’s burden of proof when it prosecutes for insider trading. Specifically, the primary issue involves whether Salman’s “tipper” had received the kind of “personal benefit” required by precedent to hold Salman criminally liable for insider trading. The United States Court of Appeals for the Ninth Circuit affirmed Salman’s conviction. However, just two years ago, the United States Court of Appeals for the Second Circuit overturned the convictions of several insider traders because the government failed to establish that the insiders had received “a potential gain of a pecuniary or similar valuable nature.” In other words, the Second Circuit rejected governmental theories where insider tips were given to friends or even family members without any monetary gain to the insider. Thus, the Court’s ruling in Salman will also settle a current split between the Second and Ninth Circuits.

By way of background, for tipper–tippee cases, courts have determined that it is a crime for an insider with a duty of confidentiality (otherwise known as a tipper) to intentionally or recklessly provide confidential information (otherwise known as a tip) to another (otherwise known as the tippee) and to receive a personal benefit, directly or indirectly, from such action. The tippee, to be criminally liable, must also know about the confidential nature of the information (which has been breached) and the benefit the insider received. The Court specified much of these requirements in Dirks v. SEC, 463 U.S. 646 (1983), where it also stated “absent some personal gain, there has been no breach of duty to stockholders.” 

How is personal gain defined? This is the main question the Court must decide in Salman, thereby resolving the federal circuit split. In Salman, the Court seemed both unwilling to take steps away from its prior precedent and suspect of the additional sweeping arguments made by the petitioner and the government. During the petitioner’s argument, Salman’s attorney contended that a line needed to be drawn as to what constituted a personal benefit. She suggested that the Court require the benefit to be tangible—not necessarily monetary or personal—but tangible. Justice Breyer, however, countered that helping “a close family member is like helping yourself.” Justice Kennedy clarified that in the law of gifts “we don’t generally talk about benefit to the donor” but that giving to a family member “ennobles you.”

The Justices’ statements appeared to indicate that they seemed more comfortable agreeing with the government, that insider information packaged as gifts to close friends or family crossed the line into creating or manifesting personal gain for the tipper, consistent with precedent. But they appeared unwilling to go further than that, despite the government’s urging that insider trading occurs whenever the insider provides confidential information for the purpose of obtaining a personal advantage for somebody else, regardless of previous or future relationships between the tipper and tippee. The government seemed not to view the personal advantage as a gain or benefit as those words are used colloquially. Instead, the government contended that the access to and communication of the confidential information in breach of the duty of confidentiality is in and of itself “a personal gain,” “a gift with somebody else’s property.” This interpretation was met with skepticism by the Court and the government seemed to back away from its argument, stating instead that it would not seek to hold liable somebody who was “loose in their conversations but had no anticipation that there would be trading.”

Justice Alito commented disapprovingly that neither side’s argument was consistent with the Court’s precedent in Dirks. Indeed, the Court appeared worried that any outcome other than affirmance would require new lines to be drawn. Any change to the law, as a result of this case, would impact the Court’s own judicially created insider trading standard from Dirks. As Justice Kagan put it to the petitioner: “[y]ou’re asking us to cut back significantly from something that we said several decades ago, something that Congress has shown no indication that it’s unhappy with, . . . [when] the integrity of the markets are a very important thing for this country. And you’re asking us essentially to change the rules in a way that threatens that integrity.” By the end of the argument, the government basically summarized what seemed to many observers, the Court’s preference: “If the Court feels more comfortable given the facts of this case of reaffirming Dirks and saying that was the law in 1983, it remains the law today, that is completely fine with the government.”

In light of the arguments and interactions with the Justices, the Court seems most comfortable with reaffirming the standards established with Dirks. Thus, it appears that despite the ruling in Newman, Salman may have provided the Court with nothing more than an opportunity to affirm its long-standing precedent.

Sixth Circuit Weighs Challenge to its Jurisdiction in Lawsuit Brought by GOP Committees against the SEC

The Republican parties of three states—Tennessee, Georgia, and New York—recently brought a lawsuit in the Sixth Circuit Court of Appeals against the Securities and Exchange Commission to challenge revised Rule G-37, which the Municipal Securities Rulemaking Board (“MSRB”) published earlier this year to limit pay-to-play practices in the municipal securities area. The revision extended Rule G-37 to cover not only brokers and dealers of municipal securities but also municipal advisers. It prohibits those advisers from engaging in municipal advisory business with a municipal entity for two years if the adviser, its staff, or its political action committee made a significant contribution to an official who could influence the award of municipal securities business. The rule also requires certain covered entities, such as municipal advisers, to publicly disclose contributions to government officials. The plaintiffs claim this new extension of the rule infringes upon the constitutionally protected First Amendment right of municipal advisers to make political contributions.

This lawsuit is not the first time these plaintiffs have attempted to challenge the constitutionality of regulations that limit the political contributions of certain financial players. In 2014, the New York and Tennessee Republican Parties filed a similar complaint in federal court in the District of Columbia that challenged, among other things, the constitutionality of SEC Rule 206(4)-5, which prohibited investment advisers from receiving compensation for services to government pension plan clients when those advisers made campaign contributions to parties or candidates who had the ability to influence awards of public investment advisory contracts. The district court dismissed the complaint on a technicality because the Securities Exchange Act of 1934 gives the courts of appeals exclusive jurisdiction to hear challenges to final orders promulgated by the SEC and then only if such challenges are brought within sixty days of promulgation of the rule. The D.C. Circuit Court affirmed.

Back in the Sixth Circuit, the plaintiffs learned their lesson from the D.C. Circuit and timely filed this complaint with the court of appeals. However, last week the SEC filed a motion to dismiss for lack of jurisdiction and the Sixth Circuit issued a halt to the briefing schedule to decide the potentially dispositive motion. In its motion to dismiss, the SEC argued that the Sixth Circuit did not have jurisdiction over this controversy because the SEC did not issue a final order or perform any action that would provide the Court with jurisdiction over the MSRB’s amendment to Rule G-37. In fact, the SEC claims Congress precluded it from using any funds to finalize, issue, or implement an order regarding the disclosure of political contributions, which the recently revised Rule G-37 requires municipal advisers to do. The SEC contends this same prohibition may in fact prohibit it from using funds to defend the MSRB rule on its merits. In their opposition filed yesterday, the plaintiffs strongly disagreed with these contentions. With Citizens United as backdrop, a challenge to these types of rules, which curtail political contributions, may have some teeth if a court ever actually gets to the substantive merits. The SEC has handed the Sixth Circuit a procedural “out” with its motion to dismiss, and it will be interesting to see if the court decides to take it.