CFTC Divisions Publish Inaugural Exam Priorities

In an effort to increase awareness and attention by regulated entities, the CFTC’s divisions of Market Oversight (DMO), Swap Dealer & Intermediary Oversight (DSIO), and Clearing & Risk (DCR) announced their 2019 examination priorities. This marks the first time that the agency has published division examination priorities, and Chairman Giancarolo commended CFTC leadership and staff for their work in bringing additional transparency into the CFTC’s agenda.

DMO Priorities

Tasked with oversight of trade execution facilities, DMO focuses its examination priorities on  designated contract markets (DCMs) and swap execution facilities (SEFs). DMO’s Compliance Branch conducts examinations of DCMs to monitor their compliance with the Commodity Exchange Act and CFTC regulations. Throughout 2018 the Compliance Branch completed a review of 11 DCM’s self-regulatory operations. Based on this review, and feedback from the DCM staff, the division identified the following topics for in-depth examination in 2019:

  • cryptocurrency surveillance practices;
  • surveillance for disruptive trading (including DCMs’ rules, surveillance practices, investigations, and disciplinary cases);
  • trade surveillance practices (selected elements);
  • block trade surveillance practices;
  • market surveillance practices (selected elements);
  • real-time market monitoring practices;
  • practices around market maker and trading incentive programs; and
  • DCMs’ relationships with and services received from regulatory service providers.

While SEFs will not be subject to 2019 examinations, given the pending regulatory changes to Part 37 rules, DMO’s Compliance Branch will conduct regulatory consultations with a number of SEFs and begin designing a SEF examination program.

According to the DMO, most of the nation’s registered DCM’s can expect to undergo at least one examination during the course of 2019. Additionally, the CFTC anticipates regular communication with DCM’s, including quarterly calls with large and medium volume DCM’s, and bi-annual calls for smaller exchanges. These calls will further the Compliance Branch’s goals of effective communication with regulated entities. Finally, the Compliance Branch will seek to identify industry best practices through comparative examinations of DCM’s. DMO will look to share these model practices with other DCM’s, to the extent it will not violate each DCM’s confidentiality.

(See DMO 2019 Examination Priorities)

DSIO Priorities

Responsible for overseeing the registration and compliance of intermediaries, swap dealers, and major swap participants, DSIO will focus its 2019 examination priorities on the protection of customer funds. The DSIO exams will continue to monitor the activities of CFTC registrations through the review of, notices, risk management programs, financial statement filings, risk exposure reports, risk assessment reports, and chief compliance officer annual reports. In 2019, CFTC-registered intermediaries can expect the DSIO to additionally focus on:

  • withdrawal of residual interest from customer accounts;
  • accepted forms of non-cash margin;
  • compliance with segregation requirements;
  • FCM use of customer depositories;
  • FCM customer account documentation; and
  • SD/MSP relationships with third-party vendors.

DCR Priorities

DCR is responsible for the oversight of derivative clearing organizations (DCOs), including those that have been designated as systemically important by the Financial Stability Oversight Council, and performs examinations of systemically important DCOs in consultation with the Board of Governors of the Federal Reserve.

DCR’s primary goal of the examination process is to determine areas of weakness or non-compliance in activities that are critical to safe and efficient clearing. The scope and methodology for the examinations are risk-based, and tailored to individual DCOs and the products they clear. Examinations will look to assess the resilience and maturity of DCOs by reviewing its financial resources, risk management, system safeguards and cyber-security policies, practices and procedures.

Court Rules that Law Firm’s Oral Summaries to SEC of Interview Notes and Memoranda Constitutes Waiver of Work Product Protection

We previously reported that on October 31, 2017, two former executives from General Cable Corporation (“GCC”) moved to compel Morgan Lewis & Bockius LLP (“Morgan Lewis”) to produce interview memoranda and notes created during an internal investigation of GCC that were subsequently provided to the SEC and an independent auditor. In S.E.C. v. Herrera, et al., No. 17-20301, 2017 WL 6041750 (S.D. Fla. Dec. 5, 2017), the issue before the court was whether Morgan Lewis “waived work product protection when it voluntarily gave the SEC oral summaries of the work product notes and memoranda its attorneys prepared about interviews of its client’s executives and employees.” On December 5, 2017, Magistrate Judge Jonathan Goodman issued a ruling ordering Morgan Lewis to produce the notes and memoranda for the interviews the firm discussed with the SEC.

As a matter of background, GCC retained the law firm to conduct an internal investigation after the company announced that it had identified accounting errors related to inventory at its operations in Brazil. As part of its internal investigation, Morgan Lewis interviewed more than three dozen witnesses, many of which were conducted in Brazil, and prepared notes and memoranda of those interviews. According to the motion papers, Morgan Lewis “regularly communicated with the SEC, voluntarily produced documents, and routinely made Brazil-based witnesses available for interviews with the SEC.” Specifically, Morgan Lewis attorneys “met with SEC staff and provided oral downloads of 12 witness interviews.” Subsequently, a Cease and Desist Order against GCC was entered and shortly thereafter, the SEC filed suit against the defendants alleging that they actively concealing material inventory accounting errors in violation of various securities laws.

In their motion to compel, the defendants sought all of the law firm’s interview notes and memoranda on the basis that Morgan Lewis waived work product protection by providing oral downloads of some interviews to the SEC and by providing work product, both orally and in writing, to Deloitte, GCC’s independent auditor. For its part, Morgan Lewis argued that “the oral conveyance of information derived from interviews does not waive the work product protection as to the underlying attorney notes and memoranda[,]” and if a waiver had occurred, it did not extend beyond the specific disclosures made. As for the disclosures made to Deloitte, Morgan Lewis argued that the oral conveyance or actual provision of work product to a company’s auditors does not waive the work product protection.

As an initial matter, Judge Goodman noted that “[i]n the context of work product, the question is not, as in the case of the attorney-client privilege, whether confidential communications are disclosed, but to whom the disclosure is made – because the protection is designed to protect an attorney’s mental processes from discovery by adverse parties.” This protection is waived when otherwise protected materials are “‘disclosed in a manner which is either inconsistent with maintaining secrecy against opponents or substantially increases the opportunity for a potential adversary to obtain the protected information.’” Judge Goodman “easily conclude[d]” that the SEC was an adversary of Morgan Lewis’ client, GCC, since the SEC was investigating GCC and eventually imposed a $6.5 million civil penalty against the company. Judge Goodman dismissed Morgan Lewis’ argument that the oral conveyance, as opposed to the actual production, of the notes and memoranda did not constitute a waiver, finding the oral downloads to be the “functional equivalent” of the actual notes and summaries. Judge Goodman did agree that the waiver did not extend beyond the notes and memoranda of the 12 interviews the law firm provided oral summaries of to the SEC. Judge Goodman noted that the compelling the disclosure of attorney work product is disfavored and the defendants failed to demonstrate substantial need to overcome this high hurdle. In addition, Judge Goodman denied the defendants’ request for documents produced to Deloitte holding that the disclosure of work product to Deloitte did not constitute a waiver because Deloitte is not an adversary to GCC.

On December 12, 2017, Morgan Lewis filed a motion for clarification or reconsideration of Judge Goodman’s Order. In its motion, the firm represents that the attorney notes taken during a meeting with the SEC “reflect the substance of the oral communications conveyed to the SEC by Morgan Lewis concerning the twelve interviews at issue.” Morgan Lewis requests, to avoid “manifest injustice,” that the Court review these notes in camera and then modify its Order “to provide that, instead of the interview notes and memos for the twelve interviews at issue,” only the attorney notes and a portion of an interview memo read to the SEC be produced to the Defendants. This motion is still pending and we will report back when there are further developments.

When sharing information obtained over the course of an internal investigation with a government agency, one should consider the implications such conduct has on privilege and waiver. The decision above serves as a reminder that even oral disclosures of work product to an adversary can constitute a waiver.

Ex-Executives Move to Compel Law Firm to Produce Notes from Internal Investigation

On October 31, 2017, two former executives from General Cable Corporation (“GCC”) filed a motion to compel Morgan Lewis & Bockius LLP (“Morgan Lewis”) to produce interview memoranda and notes created during an internal investigation of GCC that were subsequently provided to the SEC and an independent auditor. In S.E.C. v. Herrera, et al., No. 17-20301 (S.D. Fla. filed Jan. 24, 2017), the government alleged that Mathias Francisco Sandoval Herrera (“Herrera”) and Maria D. Cidre (“Cidre”), acting as CEO and CFO of the Latin American operations of GCC, violated various securities laws when they “actively concealed from GCC executive management material inventory accounting errors at the company’s subsidiary in Brazil, including the overstatement of inventory by tens of millions of dollars and allegations of a massive theft by GCC Brazil employees.”

GCC, a global manufacturer of copper, aluminum, and fiber optic wire and cable products, announced in October 2012 that “it had identified accounting errors relating to inventory at its Brazil operations, that its previously issued financial statements for 2009-2011, audited by [Deloitte & Touche LLP], should not be relied upon, and that it intended to issue a restatement of financials.” Following this announcement, GCC retained Morgan Lewis to conduct an internal investigation, which consisted of interviewing more than three dozen witnesses, many of which were conducted in Brazil, preparing notes and memoranda of those interviews, and preparing memoranda related to other aspects of the investigation. “After retaining Morgan Lewis, GCC reported the accounting errors to the SEC, which launched its own investigation . . . . [that] led to a Cease and Desist Order against GCC in December 2016, which required the payment of a civil monetary penalty in the amount of $6,500,000.”

In their motion to compel, the defendants state that during the internal investigation, Morgan Lewis “regularly communicated with the SEC, voluntarily produced documents, and routinely made Brazil-based witnesses available for interviews with the SEC.” The defendants allege that Morgan Lewis shared work product with the SEC both orally and in writing, and with this work product, the SEC had a “decided advantage” in the litigation by being able to “focus its investigation and decide which of the nearly 40 witnesses – many of whom where GCC employees in Brazil – to interview and from whom to elicit sworn statements during the investigation.” Additionally, during Morgan Lewis’ internal investigation, “Deloitte independently formed a forensic team to assess the sufficiency of the Morgan Lewis investigation.” Deloitte served as GCC’s independent auditor and issued unqualified opinions on GCC’s financial statements during the relevant time period. The defendants state that Deloitte had reason to believe that it would be charged by the SEC in connection with its audits of GCC and that Morgan Lewis “regularly shared its work product” with Deloitte, both orally and in writing.

In light of these disclosures, the defendants served Morgan Lewis with a subpoena seeking, among other items, notes and memoranda from Morgan Lewis’ witness interviews. In response, Morgan Lewis “declined to produce any documents on the basis of privilege, including the attorney-client privilege, the work-product doctrine, and the certified public accountant-client privilege.” While the defendants do not dispute that the interview memoranda were prepared by Morgan Lewis in anticipation of litigation, they argue that Morgan Lewis waived privilege when it provided written interview notes and memoranda to the SEC, an adversarial investigative agency, as well as oral downloads of each. As for documents and information shared orally with Deloitte, the defendants concede that the majority of courts have held that independent or outside auditors typically share a common interest with the corporation for purposes of the work-product doctrine and waiver analysis, but argue that in the present case, Deloitte does not share a common interest with GCC due to the fact that Deloitte was potentially a target of the SEC. Specifically, defendants argue that “Deloitte was a potential adversary to GCC because Deloitte was motivated to claim that GCC personnel had misled Deloitte regarding accounting practices at GCC[,]” and “Deloitte was a potential conduit of information to the SEC in an effort to avoid or minimize its own liability.”

In opposition, Morgan Lewis makes three primary arguments as to why it should not be compelled to produce its interview memoranda and notes: (1) courts strong disfavor ordering the production of such materials; (2) defendants failed to demonstrate that Morgan Lewis waived the work product protection; and (3) defendants failed to demonstrate a substantial need for these materials. As an initial matter, Morgan Lewis notes that the materials sought are neither transcripts nor witness statements, but rather are attorney summaries of relevant information derived from witness interviews. Morgan Lewis relies on the Supreme Court’s Upjohn decision to argue that “‘[f]orcing an attorney to disclose notes and memoranda of witness’ oral statements is particularly disfavored because it tends to reveal the attorney’s mental processes[,]” and absent a showing of waiver, defendants must show a substantial need for the materials to prepare a defense.

As for defendants’ waiver argument, Morgan Lewis argues that the PowerPoint presentation prepared for the SEC is not work product, but a collection of facts and therefore the issue of waiver is inapplicable in that instance. In addition, Morgan Lewis contends that “the oral conveyance of information derived from interviews does not waive the work product protection as to the underlying attorney notes and memoranda[,]” and if a waiver has occurred, the waiver does not extend beyond the specific disclosures made. As for the disclosures made to Deloitte, Morgan Lewis argues that the oral conveyance or actual provision of work product to a company’s auditors does not waive the work product protection.

Finally, Morgan Lewis states that defendants have failed to show a substantial need for the sought after materials. Morgan Lewis argues that a speculation that the passage of time has causes witness memories to fade does not rise to a level that overcomes the work product protection. In any event, defendants are in possession of the 400,000-plus documents that General Cable produced to the SEC, which can be used to refresh the recollections of the witnesses.

We will monitor the pending motion and report on further developments.

Second Circuit Will Not Revisit Opinion Barring Testimony Compelled by Foreign Sovereigns

On Thursday, the United States Court of Appeals for the Second Circuit refused to revisit a July 2017 decision by a panel of that court in United States v. Allen, which held, among other things, that the Fifth Amendment prohibits the use of compelled testimony in U.S. criminal proceedings, even when the testimony was lawfully compelled by a foreign sovereign. Thursday’s Order is significant because it ensures that the Allen decision is the law of the Second Circuit, and the government’s only remaining option to challenge Allen is to petition the United States Supreme Court for review.

The circumstances in Allen arose in the wake of the well-publicized LIBOR rate manipulation scandal. Among many other prosecutions, the United States sought to prosecute two citizens of the United Kingdom – Anthony Allen and Anthony Conti. Allen and Conti worked in the London office of a European bank, and were responsible for the bank’s U.S. dollar LIBOR submissions. The United States indicted Allen and Conti for wire fraud, bank fraud, and related conspiracy charges for allegedly manipulating the bank’s LIBOR submissions in favor of the bank’s trading positions. Following a full trial, Allen and Conti were convicted.

Allen and Conti appealed their convictions – and for good reason. Before being indicted in the United States, both Allen and Conti gave testimony to the U.K. Financial Conduct Authority (“FCA”) in connection with a nearly identical LIBOR manipulation investigation. Allen and Conti’s testimony to the FCA was compelled under penalty of imprisonment, and there is no Fifth Amendment analogue in such proceedings that shields an individual from giving self-incriminating testimony. A separate target of the FCA’s LIBOR investigation was then allowed to review Allen and Conti’s compelled testimony. That target subsequently became a cooperating witness for the United States – giving statements to the FBI, and ultimately testifying as a government witness at Allen and Conti’s trial. In addition, the FBI agent who testified in the grand jury to secure Allen and Conti’s indictment relayed information that was provided to the government exclusively through the cooperating witness.

On appeal, the Second Circuit overturned Allen and Conti’s convictions, dismissed their indictments, and clarified the boundaries of the Fifth Amendment in the process. First, the court held that the Fifth Amendment’s prohibition on the use of compelled testimony applies even when a foreign sovereign has compelled the testimony (and even when the foreign sovereign has acted perfectly lawfully in doing so). Second, if the prosecution uses a witness who has had substantial exposure to a defendant’s compelled testimony, the prosecution must prove that the witness’s review of the compelled testimony did not shape, alter or affect the evidence used in the grand jury or at trial. Moreover, where a witness has materially altered his testimony after being substantially exposed to a defendant’s compelled testimony, the government must produce something more than a bare, generalized denial that the witness’ testimony was tainted by the compelled testimony.

With Allen now firmly cemented as the law of the Second Circuit, there is more reason than ever to believe that its holdings will impact not only investigations and prosecutions in the Second Circuit, but throughout the entire country.

While the facts of Allen involved criminal prosecution, it is likely that Allen will impact SEC investigations. First, the Fifth Amendment provides protection to individuals under investigation by the SEC in that the SEC cannot compel individuals to testify against their own interest. That protection is limited because the SEC, as a civil litigant, is usually entitled to an adverse inference when an individual asserts the privilege. However, if the SEC receives compelled testimony from the FCA, it would appear that under Allen that the SEC would be prevented from using the substantive testimony in any subsequent prosecution. Second, given how often the SEC staff coordinates with the criminal authorities, the SEC staff will have to be very careful about sharing the substance of foreign compelled testimony with witnesses that the criminal authorities may want to use in any parallel criminal prosecution.

SEC Announces Enforcement Division Cyber Specialty Unit

On September 25, 2017, the Securities and Exchange Commission announced the creation of an Enforcement Division “Cyber Unit” that will focus on cyber-related violative conduct. The timing of this is much more than coincidental; indeed it’s obvious. Just last week, SEC Chairman Jay Clayton disclosed: 1) a 2016 intrusion of the SEC’s EDGAR system due to a software vulnerability in the test filing component of the system, resulting in access to nonpublic information; and 2) the creation of a senior-level cybersecurity working group. Since the disclosure of the EDGAR breach, the financial press has reported that SEC Enforcement, the Secret Service, and the FBI have been investigating, and that Chairman Clayton asked the SEC’s Office of Inspector General to investigate. On September 26, 2017, Chairman Clayton appears before the Senate Committee on Banking, Housing, and Urban Affairs where he will provide testimony and likely be subject to intense questioning.

Returning to the SEC’s Cyber Unit, while not specifically described as such, it appears to be created in the mold of the other Enforcement Division Specialty Units. This new unit’s mandate includes targeting cyber-related violative conduct, such as: market manipulation schemes involving false information spread through electronic and social media; hacking to obtain material nonpublic information; misuse of distributed ledger technology; misconduct perpetrated via the dark web; intrusions into retail brokerage accounts; and cyber-related threats to trading platforms and other critical market infrastructure. Consistent with this being a new specialty unit, the “Chief” is a former Co-Chief of the SEC’s Market Abuse Specialty Unit. Thus, registrants can expect the Cyber Unit to evolve much as the SEC’s other specialty units have previously. Specifically, this unit will likely: develop and expand SEC internal cyber knowledge; seek to hire external cyber experts; and dedicate its efforts and resources to this specialty area. Consistent with the evolutions of the other specialty units, the Cyber Unit will likely pursue cases that the Enforcement Division generally and historically might not have pursued, such as non-fraud violations considered more technical in nature.

While it’s ironic that the SEC announced the Cyber Unit on the heels of its recent breach, issuers and registrants should take this opportunity to self-assess and implement plans to avoid the SEC’s Cyber Unit in the future. Among various strategies, actively monitoring and assessing the SEC’s cybersecurity guidance and, in particular, the Office of Compliance Inspections and Examinations Risk Alerts, and documenting this work will support arguments of reasonable and diligent efforts. For further and more detailed guidance, look to FINRA’s February 2015 Report on Cybersecurity Practices. While FINRA’s oversight is limited to its member broker-dealer firms, this 46-page report provides plain-language guidance that any company or firm may want to consider reviewing and implementing as appropriate.

Split Second Circuit Affirms Insider Trading Conviction While Rejecting Newman’s “Meaningfully Close Personal Relationship” Requirement

On August 23, 2017, the United States Court of Appeals for the Second Circuit affirmed an insider trading conviction against a portfolio manager, and in doing so, held that the “meaningfully close personal relationship” requirement set forth in the Second Circuit’s landmark decision, United States v. Newman, to infer personal benefit “is no longer good law.”


Matthew Martoma (“Martoma”) managed an investment portfolio at S.A.C. Capital Advisors, LLC (“SAC”) that focused on pharmaceutical and healthcare companies. His “conviction[] stem[s] from an insider trading scheme involving securities of two pharmaceutical companies, Elan Corporation, plc (“Elan”) and Wyeth, that were jointly developing an experimental drug called bapineuzumab to treat Alzheimer’s disease.” During the development of bapineuzumab, Martoma arranged for consultation visits paid by SAC with two doctors who were working on the clinical trial. One doctor was the chair of the safety monitoring committee for the clinical trial and provided Martoma with “confidential updates on the drug’s safety that he received during meetings on the safety monitoring committee.” The other doctor, a principal investigator on the clinical trial, provided Martoma with “information about the clinical trial, including information about his patients’ responses to the drug and the total number of participants in the study.”

In July 2008, one of these two doctors was selected to present the results of “Phase II” of the clinical trial at the International Conference on Alzheimer’s Disease, but prior to the conference, the doctor identified “‘two major weaknesses in the data that called into question the efficacy of the drug as compared to the placebo.” Martoma spoke with this doctor on two occasions, including an in-person meeting where the doctor shared with Martoma “the efficacy results and discussed the data with him in detail.” Martoma subsequently spoke with the owner of SAC and prior to the public announcement of the efficacy results, “SAC began to reduce its position in Elan and Wyeth securities by entering into short-sale and options trades that would be profitable if Elan’s and Wyeth’s stock fell.” When the final results from the clinical trial were publicly presented approximately a week later, Elan’s and Wyeth’s share prices declined and the “trades that Martoma and [SAC’s owner] made in advance of the announcement resulted in approximately $80.3 million in gains and $194.6 million in averted losses for SAC.”

The Appeal

In February 2014, following a four-week jury trial, Martoma was convicted of one count of conspiracy to commit securities fraud in violation of 18 U.S.C. § 371 and two counts of securities fraud in connection with an insider trading scheme. Martoma appealed his conviction primarily on two grounds—“that the evidence presented at trial was insufficient to support his conviction and that the district court did not properly instruct the jury in light of the Second Circuit’s decision in United States v. Newman, issued after Martoma was convicted.” Specifically, Martoma argued that there was no “meaningfully close personal relationship” as set forth in Newman between him and the doctor, and that the doctor did not receive any “‘objective, consequential . . . gain of a pecuniary or similarly valuable nature’ in exchange for providing Martoma with confidential information.” Martoma also argued that the jury instructions were inadequate because they “did not inform the jury about the limitations on ‘personal benefit’” as set forth in Newman.

The majority summarily rejected Martoma’s sufficiency of evidence argument finding that Martoma was a “frequent and lucrative client” of the doctor who was paid $1,000 for approximately 43 consulting sessions where the doctor regularly disclosed confidential information. Relying on Newman, the court noted that “‘the tipper’s gain need not be immediately pecuniary,’ and . . . that ‘enter[ing] into a relationship of quid pro quo with [a tippee], and therefore hav[ing] the opportunity to . . . yield future pecuniary gain,’ constituted a personal benefit giving rise to insider trading liability.” The court held that even though the doctor was not paid for the two consultations on the efficacy results, under the pecuniary quid pro quo theory, a “rational trier of fact could have found the essential elements of the crime [of insider trading] beyond a reasonable doubt.”

The crux of the decision lies in Martoma’s challenge to the adequacy of the lower court’s jury instruction. To complicate matters, during the pendency of the appeal, both the Second Circuit and the Supreme Court issued decisions that weighed heavily into the court’s analysis. First, in United States v. Newman, which we previously reported on here, the Second Circuit held, in relevant part, that a trier of fact could not infer that a tipper personally benefitted from disclosing information as a gift unless that gift was made to someone with whom the tipper had a “meaningfully close personal relationship.” This requirement was derived from an example the Supreme Court provided in Dirks v. S.E.C., 463 U.S. 646 (1983), where an insider is deemed to have personally benefited when disclosing inside information as “a gift . . . to a trading relative or friend.” Subsequently, in Salman v. United States, which we previously reported on here, the Supreme Court found as obvious that an insider personally benefits from trading on inside information and then giving the proceeds as a gift to his brother, and an insider “‘effectively achieve[s] the same result by disclosing the information to [the tippee], and allowing him to trade on it,’ because ‘giving a gift of [inside] information is the same thing as trading by the tipper followed by a gift of the proceeds.’”

Acknowledging that the discussion of gifts in both Dirks and Salman were “largely confine[d]” within the context of gifts to trading relatives and friends, and that the Supreme Court in Salman did not explicitly hold that gifts to anyone, including non-relatives and non-friends, can give rise to the personal benefit necessary to establish insider trading liability, the Second Circuit determined that “the straightforward logic of the gift-giving analysis in Dirks, strongly reaffirmed in Salman, is that a corporate insider personally benefits whenever he ‘disclos[es] inside information as a gift . . . with the expectation that [the recipient] would trade’ on the basis of such information or otherwise exploit it for his pecuniary gain.” Against this backdrop, the Second Circuit held that:

[A]n insider or tipper personally benefits from a disclosure of inside information whenever the information was disclosed “with the expectation that [the recipient] would trade on it,” and the “disclosure resemble[s] trading by the insider followed by a gift of the profits to the recipient,” whether or not there was a “meaningfully close personal relationship” between the tipper and tippee.

In other words, the Second Circuit “reject[ed], in light of Salman, the categorical rule that an insider can never personally benefit from disclosing inside information as a gift without a ‘meaningfully close personal relationship.’” Coupled with the fact that it had already determined the evidence was sufficient to support Martoma’s conviction, the Second Circuit determined that the jury instruction pertaining to personal benefit was not obviously erroneous, and even if it were, such an error did not impair Martoma’s rights.

The Dissent

Of note in an already notable decision is the scathing dissent, which is lengthier than the majority opinion, authored by Judge Pooler. Judge Pooler opined that by expanding the recipient of a gift from a “trading relative or friend” as set forth in Dirks to any person, the “majority strips the long-standing personal benefit rule of its limiting power.” Judge Pooler expressed particular disagreement with the majority’s application of Salman to overturn Newman’s “meaningfully close personal relationship” requirement because the Supreme Court explicitly overturned the second holding in Newman that had required a showing of a monetary or other gain in conjunction with a gift of information to a trading relative or friend, but left untouched the first holding that there must be a “meaningfully close personal relationship” to infer a personal benefit from a gift. She states:

In the past, we have held that an insider receives a personal benefit from bestowing a “gift” of information in only one narrow situation. That is when the insider gives information to family or friends—persons highly unlikely to use it for commercially legitimate reasons. Today’s opinion goes far beyond that limitation, which was set by the Supreme Court in Dirks, received elaboration in this Court’s opinion in Newman, and was left undisturbed by the Supreme Court in Salman. In rejecting those precedents, the majority opinion significantly diminishes the limiting power of the personal benefit rule, and radically alters insider-trading law for the worse.


This ruling unwinds the landmark Newman decision, which limited the circumstances that a gift of information could be inferred as receipt of a personal benefit, but how long the ruling will remain in effect is unclear. It is possible that the Second Circuit will review the case en banc, or that the Supreme Court will grant certiorari should Martoma seek it, particularly in light of the fact that Newman’s “meaningfully close personal relationship” requirement was not an issue in front of the Supreme Court in Salman since the case involved two brothers. For the time being, however, the decision allows prosecutors to go forward with insider trading cases that may have been previously foreclosed under Newman’s “meaningfully close personal relationship” requirement.

7th Circuit Affirms 1st Conviction For Spoofing

Spoofing is not going away after all. Last week, the U.S. Court of Appeals for the Seventh Circuit unanimously upheld the first-ever criminal conviction for spoofing. The case, United States v. Coscia, 7th U.S. Circuit Court of Appeals, No. 16-3017, involved a multi-count indictment against futures trader Michael Coscia. The indictment alleged that Coscia engaged in illegal trading by employing computer algorithms that engaged in market activity that violated the anti-spoofing laws created and adopted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The indictment alleged that Coscia traded in a variety of futures products and made over $1.4 million as a result of his illegal trading.

By way of background, spoofing involves placing bids or offers to sell futures contracts with the intent to cancel the bids or offers before execution. By placing bids or offers, which were never intended to be executed, “spoofers” create an illusion of supply or demand that can influence prices to benefit their other positions in the markets. Accordingly, Coscia placed small orders on one side of the market and then rapidly placed large orders on the opposite side to create the appearance of increased volume pressure. This apparent increased volume on the opposite side caused other market participants to trade against Coscia’s small orders. Coscia then cancelled the large “spoof” orders, which he had never intended to be executed in the first place.

After a seven-day long trial in November 2015, an Illinois federal jury found Coscia guilty of all counts in the indictment. In July 2016, the Honorable Harry D. Leinenweber sentenced Coscia to three years in prison and two years of supervised release. Coscia is currently serving his sentence in a New Jersey federal prison. On appeal, Coscia and his lawyers argued that: the anti-spoofing statute was unconstitutionally vague; there was insufficient evidence at trial to support the conviction; and the district court erred in sentencing by improperly measuring the amount of the loss. The remainder of this article focuses on the Seventh Circuit’s denial of Coscia’s first two arguments.

The constitutionality of the spoofing laws has remained controversial since their adoption. Now, however – with a unanimous opinion – the Seventh Circuit has upheld their constitutionality.  In fact, the language of the opinion so clearly supports constitutionality that the panel appears dismissive of Coscia’s arguments. “The anti‐spoofing provision provides clear notice and does not allow for arbitrary enforcement,” U.S. Circuit Judge Kenneth Ripple wrote. “Consequently, it is not unconstitutionally vague.” United States v. Coscia, No. 16-3017, 2017 WL 3381433 at *1, — F.3d – (7th Cir. Aug. 7, 2017), available here.

The Seventh Circuit also held that based on the evidence presented at trial, a reasonable trier of fact could have concluded that Coscia had the requisite intent. The Seventh Circuit specifically reviewed the evidence of Coscia’s purposeful design and use of two computer algorithmic trading programs which were designed to repeatedly place small buy or sell orders in the market, followed by the rapid placement and cancellation of large orders on the opposite side of the market of his small orders. The Seventh Circuit pointed to the testimony of the designer of Coscia’s computer algorithms, as evidence of Coscia’s intent. At trial, this witness explained that the programs he designed for Coscia were meant to “act like a decoy.” Id. at *4. Although the Seventh Circuit noted that there was not a “single piece of evidence” (id. at *10) that necessarily established spoofing, it concluded that based on the totality of the evidence at trial, a rational trier of fact could conclude that “Mr. Coscia engaged in this behavior in order to inflate or deflate the price of certain commodities,” and “[h]is trading accordingly also constituted commodities fraud[.]” Id. at *15.

While the Seventh Circuit did not provide specific factors or elements to be cited to in the future regarding spoofing, the Seventh Circuit did detail its analysis of the evidence to support its affirmation of the conviction.

A review of the trial evidence reveals the following. First, Mr. Coscia’s cancellations represented 96% of all Brent futures cancellations on the Intercontinental Exchange during the two‐month period in which he employed his software. Second, on the Chicago Mercantile Exchange, 35.61% of his small orders were filled, whereas only 0.08% of his large orders were filled. Similarly, only 0.5% of his large orders were filled on the Intercontinental Exchange. Third, the designer of the programs, Jeremiah Park, testified that the programs were designed to avoid large orders being filled.   Fourth, Park further testified that the “quote orders” were “[u]sed to pump [the] market,” suggesting that they were designed to inflate prices through illusory orders.   Fifth, according to one study, only 0.57% of Coscia’s large orders were on the market for more than one second, whereas 65% of large orders entered by other high‐frequency traders were open for more than a second. Finally, Mathew Evans, the senior vice president of NERA Economic Consulting, testified that Coscia’s order‐to‐trade ratio was 1,592%, whereas the order‐to‐trade ratio for other market participants ranged from 91% to 264%. As explained at trial, these figures “mean[] that Michael Coscia’s average order [was] much larger than his average trade”—i.e., it further suggests that the large orders were placed, not with the intent to actually consummate the transaction, but rather to shift the market toward the artificial price at which the small orders were ultimately traded.

We believe that, given this evidence, a rational trier of fact easily could have found that, at the time he placed his orders, Mr. Coscia had the “intent to cancel before execution.” (emphasis added). Id. at *10.

In conclusion, the Seventh Circuit’s opinion provides us with several takeaways:

  • Spoofing is not going away, and this ruling will embolden prosecutors and the futures regulators. This likely qualifies as the most successful prosecution to date by the Securities and Commodities Fraud Section at the U.S. Attorney’s Office for the Northern District of Illinois. That said, criminal investigations and prosecutions require proving violations beyond a reasonable doubt. Thus, any potential uptick in spoofing criminal cases will be tempered accordingly. Regarding the U.S. Commodity Futures Trading Commission (“CFTC”) and the futures self-regulatory organizations, such as the Chicago Mercantile Exchange and the Intercontinental Exchange, they will continue to prioritize aggressively investigating and civilly prosecuting spoofing through their enforcement programs in light of this ruling.
  • The increased regulatory and industry emphasis on trading surveillance will continue to accelerate. For those market participants with a business model that presents a greater risk of being subjected to these investigations – if not already doing so – they need to consider implementing a trading surveillance system. Several fintech firms provide surveillance systems to market participants and other market participants (with the resources and capabilities) have developed proprietary systems internally. While not currently a regulatory requirement, the CFTC has sent messages via its enforcement program emphasizing trading surveillance by including it as part of the undertakings in two of its high-profile spoofing settlements this past year.
  • Lastly, as mentioned above, the Seventh Circuit did not provide factors or elements, but did detail the evidence that supported the conviction. In addition to the witness testimony, the Seventh Circuit discussed two quantifiable metrics that market participants can use to monitor and detect potential manipulative activity. These two metrics are the: 1) order-to-trade ratio; and 2) order duration. First, the order-to-trade compares the amount of orders entered to the amount of executed trades. Two aspects of this ratio worked to Coscia’s detriment; a) his order-to trade ratio exponentially exceeded the ratios for other market participants; and b) the large lot sizes for his placed and cancelled orders routinely and significantly exceeded the small lots sizes for his executed trades. Second, regarding order duration, the Seventh Circuit found that according to one study only 0.57% of Coscia’s large orders rested in the market for more than one second, whereas 65% of large orders entered by other high-frequency traders remained open in the market for more than one second. Thus, when compared to other market participants, the lower the order-to-trade ratio and the longer the order duration, the stronger the arguments that market participants will have to attempt to avoid investigation and prosecution. While algorithmic, high-frequency trading is very complex, these two metrics are fairly straightforward and implementing and monitoring these metrics may provide market participants with defenses to avoid a similar fate.

SEC Names Co-Directors of Enforcement

Last week, the Securities and Exchange Commission (SEC) announced that Acting Enforcement Director Stephanie Avakian and former federal prosecutor Steven Peikin had been named Co-Directors of the Division of Enforcement. In making the announcement, SEC Chairman Jay Clayton advised:

There is no place for bad actors in our capital markets, particularly those that prey on investors and undermine confidence in our economy. Stephanie and Steve will aggressively police our capital markets and enforce our nation’s securities laws as Co-Directors of the Division of Enforcement. They have each demonstrated market knowledge, impeccable character, and commitment to public service, and I am confident their combined talents and experience will enable them to effectively lead the Division going forward.

Prior to being named Acting Director in December 2016, Ms. Avakian served as Enforcement’s Deputy Director since June 2014. Mr. Peikin joins the SEC for the first time from private practice. Prior to that, from 1996 to 2004, Mr. Peikin served as an Assistant U.S. Attorney in the Southern District of New York. He was Chief of the Office’s Securities and Commodities Fraud Task Force, where he supervised some of the nation’s highest profile prosecutions of accounting fraud, insider trading, market manipulation, and abuses in the foreign exchange market. As a prosecutor, Mr. Peikin also personally investigated and prosecuted a wide variety of securities, commodities, and other investment fraud schemes, as well as other crimes.

As Chairman Clayton continues to appoint the Division leadership at the SEC and establish his own agenda for the Commission as its new Chairman, these Co-Director appointments bear a strong resemblance to those of his predecessors, Chair Mary Jo White and Chair Mary Schapiro. First, in 2009, Chair Schapiro appointed a former federal prosecutor for the first time to lead the SEC’s Division of Enforcement. Second, in 2013, Chair White appointed another former federal prosecutor, Andrew Ceresney. In furtherance of the striking similarities, Chair White appointed Mr. Ceresney as a Co-Director with the then Acting Director. Mr. Ceresney eventually took over the Directorship on his own. Thus, while many forecasted that the new Commission may perhaps be friendlier to the industry, with these Co-Director appointments Chairman Clayton looks to be following the lead of his recent predecessors rather than breaking from them. Lastly, if the precedent of the only prior Co-Directorship is any indication, then at some point in the foreseeable future Mr. Peikin will be occupying the Director’s chair on his own, as Mr. Ceresney ultimately did.