Jim Lundy Appointed as Independent Monitor in the CFTC v. 3Red Trading & Oystacher Manipulative Trading / Spoofing Matter

Chicago partner Jim Lundy was appointed by the Honorable Judge Amy J. St. Eve of the U.S. District Court for the Northern District of Illinois to serve as the independent monitor for one of the first “spoofing” manipulative trading enforcement actions instituted by the Commodities Futures Trading Commission (CFTC). Jim’s appointment is part of a settlement between the CFTC and 3Red Trading LLC and its principal, Igor B. Oystacher, entered on December 20, 2016. Over the next three years, Jim will be responsible for monitoring the trading of 3Red and Oystacher, and identifying any future violations of the Commodity Exchange Act and CFTC Regulations as charged and pursuant to a monitoring agreement.

The CFTC filed its initial complaint on October 19, 2015. In its complaint, the CFTC alleged the employment of manipulative trading / spoofing by the Defendants in the markets for E-Mini S&P 500, Copper, Crude Oil, Natural Gas, and VIX futures contracts on multiple exchanges.

In addition to the monitorship, as part of the settlement 3Red and Oystacher agreed to pay a $2.5 million penalty, jointly and severally. Judge St. Eve also ordered 3Red and Oystacher to employ certain compliance tools with respect to Oystacher’s futures trading on U.S. exchanges for an 18-month period, and permanently prohibited the Defendants from spoofing and the employment of manipulative or deceptive devices while trading futures contracts.

Additional information on the settlement and Jim’s appointment is discussed in Crain’s Chicago Business, 3 Red agrees to $2.5 million fine, monitoring.” (Log-in may be required).

Jim joined Drinker Biddle after working at the SEC for 12 years. During his tenure, he served in the Enforcement Division as a Senior Trial Counsel and a Branch Chief and in the Office of Compliance Inspections and Examinations as a Senior Regulatory Counsel, where he assisted with operating the SEC’s broker-dealer examination program for the Midwest Region. Prior to joining Drinker Biddle, Jim worked in-house at a futures and securities brokerage firm affiliated with a European-based global bank and represented his firm before futures regulators, FINRA, and the SEC.

In Jim’s practice he represents clients in matters involving the various regulatory bodies with enforcement, examination, and policy oversight of the securities and futures industries.

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.).

SEC Levies Disgorgement and Civil Penalties for Violations of the Consumer Protection Rule and the Dodd-Frank Whistleblower Protection Rule

On June 23, 2016, Merrill Lynch, Pierce, Fenner & Smith Incorporated and Merrill Lynch Professional Clearing Corp. (collectively, “Merrill Lynch”) agreed to pay $415 million and admit wrongdoing to settle charges of rules based violations, including Exchange Act Rule 15c3-3, the Consumer Protection Rule (the “Consumer Protection Rule”) and Exchange Act Rule 21F-17 (“Rule 21F-17”), which prohibits any action impeding an individual from communicating directly with Commission staff about possible securities laws violations. See Release No. 78141.

Exchange Act Rule 15c3-3, known as the Consumer Protection Rule, was enacted to “protect broker-dealer customers in the event a broker dealer becomes insolvent” by eliminating the “use by broker-dealers of customer funds and securities to finance firm overhead and such firm activities a trading and underwriting through the separation of customer related activities from other broker-dealer operations.” To safeguard assets, the Consumer Protection Rule requires broker-dealers to “maintain a reserve of funds and/or certain qualified securities in an account at a bank that is at least equal in value to the net cash owed to customers” and to “promptly obtain and thereafter maintain physical possession or control over customers’ fully paid and excess margin securities . . . . in one of several locations . . . held free of liens or any other interest that could be exercised by a third-party to secure an obligation of the broker-dealer.” The Consumer Protection Rule also imposes a self-reporting requirement where, in the event that a broker-dealer fails to maintain sufficient reserves, it must immediately notify the Commission and FINRA.

Signaling that the SEC may suspect that other broker-dealers may have also violated the Consumer Protection Rule, Michael J. Osnato, Chief of the SEC Enforcement Division’s Complex Financial Instruments Unit, announced in a press release: “Simultaneous with today’s action, SEC staff will begin a coordinated effort across divisions to find potential violations by other firms through a targeted sweep and by encouraging firms to self-report any potential violations of the Customer Protection Rule.” Press Release No. 2016-128. In light of the significant civil penalty imposed by the SEC against Merrill Lynch, broker-dealers should take a hard look at their own compliance with the Consumer Protection Rule and seriously consider self-reporting if they find violations as required by the Consumer Protection Rule itself.

Rule 21F-17 was enacted to “evince[] a Congressional purpose to facilitate the disclosure of information to the Commission relating to possible securities law violations and to preserve the confidentiality of those who do so.” “Implementation of the Whistleblower Provisions of Section 21F of the Securities Exchange Act of 1934,” Release No. 34-64545, at p. 198 (Aug. 12, 2011). The SEC acknowledged that it did not discover any instance where a Merrill Lynch employee was prevented from directly communicating with the Commission regarding potential securities law violations, certain Merrill Lynch policies, procedures, and agreements with employees included language that the SEC claimed did not permit an individual to voluntarily disclose confidential information. The Order further states that Merrill Lynch promptly took “substantial remedial acts” to address any Rule 21F-17 violations, including revising its severance agreements. Notably, this is the second time the Commission has held proceedings for Rule 21F-17 violations without any evidence that any employee had been prevented from disclosing confidential information to the government. See In the Matter of KBR, Inc., Release No. 74619. Given that the Consumer Protection Rule violation seems unrelated to the Rule 21F-17 violation, it seems likely we will see the staff asking about language included in employment agreements, severance agreements and other employment policies during investigations even in the absence of specific whistleblower concerns.

While Merrill Lynch admitted to wrongdoing, the settlement involves rules based violations as opposed to fraud based violations. Merrill Lynch did not admit to any fraudulent conduct. Notably, some of the largest “admit” settlements have been grounded in rules based violations. See Press Release No. 2013-187 (JPMorgan Chase admits to wrongdoing and pays $200 million and $920 million worldwide to settle SEC charges); see also Press Release No. 2014-17 (Scotttrade admits to wrongdoing and pays $2.5 million to settle SEC charges). The Commission also announced on June 23rd, a litigated administrative proceeding against William Tirrell, Merrill Lynch’s former Head of Regulatory Reporting, related to the Consumer Protection Rule violations. See Release No. 78142. The proceeding will be scheduled for a public hearing before an administrative law judge.

SEC Announces Highest Whistleblower Award to Date

The SEC recently announced a record-breaking whistleblower award of $30-35 million, which shattered the previous high award of $14 million. See SEC Awards More Than $14 Million to Whistleblower. Not only is this award noteworthy for its size, but also because it was made to a foreign resident and it could have been even higher if the whistleblower did not unreasonably delay in reporting the violations.

This was not the first award made to foreign residents, but it was the first award made to a foreign resident since the Court of Appeals for the Second Circuit found that the anti-retaliation protections of Section 21F(h) of the Dodd-Frank Act do not apply to foreign whistleblowers who experience retaliation overseas from foreign employers. Liu v. Siemens, __ F.3d __, 2014 WL 3953672 (2d Cir. Aug. 14, 2014); see also Made for the U.S.A. Only: Second Circuit Holds That the Dodd-Frank Act’s Antiretaliation Provision Applies Only Domestically. In making this award, the SEC reiterated that any extraterritorial aspects of tips, such as a whistleblower’s foreign residency or alleged misconduct that occurs abroad, do not matter when there is a “sufficient U.S. territorial nexus”—i.e., “whenever a claimant’s information leads to a successful enforcement of a covered action brought in the United States, concerning violations of the U.S. securities laws, by the Commission, the U.S. regulatory agency with enforcement authority for such violations.” Order Determining Whistleblower Award Claim, Whistleblower Award Proceeding, File No. 2014-10 (Sept. 22, 2014). It found that the Second Court’s holding in Liu v. Siemens, __ F.3d __, 2014 WL 3953672 (2d Cir. Aug. 14, 2014), was not controlling and that “the whistleblower award provisions have a different Congressional focus than the anti-retaliation provisions, which are generally focused on preventing retaliatory employment actions and protecting the employment relationship.”

In announcing the award Sean McKessy, Chief of the Office of the Whistleblower, underscored the extraterritorial reach of the program: “This award of more than $30 million shows the international breadth of our whistleblower program as we effectively utilize valuable tips from anyone, anywhere to bring wrongdoers to justice. Whistleblowers from all over the world should feel similarly incentivized to come forward with credible information about potential violations of the U.S. securities laws.” See SEC Press Release: “SEC Announces Largest-Ever Whistleblower Award.”

Further, this already staggering award amount had the potential to be even higher if the whistleblower did not unreasonably delay in reporting to the SEC. The whistleblower delayed for an undisclosed period of time after first learning of the violations, which the SEC said caused investors to suffer significant losses that might have been avoided. The SEC found that the whistlblower’s delay was unreasonable under the circumstances and reduced the award from the maximum percentage allowed under the statute. It rejected the whistleblower’s argument that the percentage awarded was below the average percentage awarded to other whistleblowers as irrelevant. The SEC, however, did not apply the unreasonable delay consideration as severely as it otherwise might have done because a period of the delay occurred before the implementation of the whistleblower program established by the Dodd-Frank Act.

This latest award shows the SEC’s willingness to make awards to whistleblowers across the globe.