Futures & Derivatives Law

Transcription

1 REPORT The Journal on the Law of Investment & Risk Management Products Futures & Derivatives Law The CFTC s New Culture of Imposing Significant and Sweeping Sanctions By Kevin J. Harnisch, David S. Mitchell, and Andrew T. Smith 1 The Commodity Futures Trading Commission ( CFTC ) is undergoing an apparent culture shift in which it will impose large penalties in order to send a serious and significant message: don t mess with markets. 2 This culture shift involves bringing high-impact cases that could influence market behavior according to the Director of the CFTC s Division of Enforcement, David Meister. 3 The CFTC s recent settlements with Royal Bank of Scotland, plc ( RBS ), UBS, and Barclays regarding alleged manipulation of LIBOR (London Inter- Bank Offered Rate) are the epitome of such high-impact cases demonstrating the CFTC s new cultural shift. 4 The CFTC obtained an unprecedented $1.2 billion in penalties from these three settlements, and total penalties paid to all relevant domestic and international government agencies amounted to $2.56 billion. These cases were the products of lengthy, globally-coordinated investigations receiving enormous press attention. Although the significant sanctions of the LIBOR-related enforcement actions are illustrative of the CFTC s recent push to impose higher monetary penalties and effect change among market participants with sweeping remedial measures, the beginnings of this type of approach could be seen in the CFTC s focus in 2012 on the segregation of customer accounts May 2013 n Volume 33 n Issue 5 in the wake of MF Global s collapse, which resulted in a $20 million settlement with J.P. Morgan Chase Bank, the largest penalty the CFTC has ever imposed for an alleged segregated funds violation. 5 In addition to negotiating tough, headlinegrabbing settlements, the CFTC has recently demonstrated a willingness to litigate cases against significant market players. For example, the CFTC is litigating landmark enforcement actions against Royal Bank of Canada for a multi-hundred million dollar alleged wash trade scheme and a more recent action against the CME Group s New York Mercantile Exchange for allegedly failing to investigate the disclosure of material nonpublic information by two former employees. Through its recent high-profile settlements and litigations, the CFTC is putting the market on notice that it will be aggressively pursuing actions against all regulated entities, no matter their size. Manipulation of LIBOR Daily LIBOR rates are issued for varying maturities (e.g., 30-day, three months, six months) by the British Bankers Association ( BBA ) and are based on offered inter-bank rates submitted in accordance with instructions set out reprint article

2 May 2013 n Volume 33 n Issue 5 Futures & Derivatives Law Report by the BBA from certain contributor banks or panel banks. 6 The panel banks submit the rate at which they could borrow funds by asking for and accepting interbank offers. 7 On February 6, 2013, the CFTC entered an order against RBS and RBS Securities Japan Limited, for allegedly making false submissions and manipulating LIBOR for the Yen and Swiss Franc from at least mid through RBS had Yen and Swiss Franc derivative positions, including interest rate swaps and money market positions, that were affected by Yen and Swiss Franc LIBOR. 9 RBS traders allegedly asked the RBS submitters to make false submissions regarding Yen and Swiss Franc LIBOR that were beneficial to RBS trading positions. 10 The CFTC s order stated that RBS lacked internal controls, procedures, and policies concerning its LIBOR submission process and failed to adequately supervise its trading desks and traders. 11 While neither admitting nor denying the CFTC s allegations, RBS agreed to pay a $325 million penalty to the CFTC and to undertake significant remedial measures, including implementation of substantial internal controls, firewalls against improper communications between traders and submitters, documenting, and retaining all factors and communications associated with LIBOR submissions, and developing rigorous standards for benchmark interest rates, including auditing, monitoring, and training concerning submissions and related processes. 12 RBS and its subsidiaries also settled similar allegations by the DOJ and FSA (U.K.), agreeing to pay penalties of $150 million and $137 million, respectively. 13 In June and December 2012, the CFTC entered orders against Barclays and UBS for their alleged involvement in the LIBOR manipulation scheme. The order against UBS alleged that UBS derivatives traders, responsible for generating a profit on their derivative portfolios, were also responsible for determining UBS LI- BOR submissions. 14 The UBS traders allegedly viewed their LIBOR submissions as mere tools to help the traders increase the profits or minimize losses on their trading positions. 15 During the financial crisis, certain UBS managers also allegedly gave instructions to err on the low side and subsequently to be in the middle of the pack for UBS benchmark interest rate submissions in order to address concerns over the bank s reputation and adverse market and press reports. 16 Similarly, the CFTC s order against Barclays alleged that senior management directed submitters to lower the bank s LIBOR submissions during the financial crisis in order to make Barclays submissions closer to rates submitted by other panel banks. 17 UBS and Barclays neither admitted nor denied the CFTC s allegations. UBS and Barclays agreed to pay penalties to the CFTC of $700 million and $200 million, respectively, and both banks agreed to undertake substantial remedial measures identical to those outlined in the RBS settlement. 18 UBS, Barclays, and their related entities also entered into settlements with the DOJ and other foreign regulators, including the FSA. 19 Customer Account Segregation Following the collapse of MF Global, the CFTC focused on examining whether firms appropriately segregate customer accounts in accordance with applicable CFTC requirements. Those efforts led to a significant settlement with J.P. Morgan Chase Bank, N.A. ( J.P. Morgan ) in which the CFTC imposed a $20 million penalty, the largest ever for alleged segregated funds violations. 20 According to the CFTC s order, from November 2006 to September 2008, J.P. Morgan served as a depository institution for Lehman Brothers, Inc. s ( LBI ) customer segregated funds and also provided LBI with intra-day credit. 21 In determining the level of intra-day credit to extend to LBI, J.P. Morgan allegedly improperly included LBI s customer segregated funds in its calculation of LBI s net free equity for purposes of determining the amount of credit it would extend to LBI. 22 In addition, J.P. Morgan allegedly improperly declined a request to release the customer segregated funds after LBI filed for bankruptcy in September High-Profile Litigation The CFTC has likewise demonstrated a willingness to litigate high-profile matters when defendants refuse to settle. For example, the CFTC recently initiated litigation against the Royal Bank of Canada ( RBC ) and the CME Group s New York Mercantile Exchange ( NYMEX ). In April 2012, the CFTC filed one of its largest enforcement actions ever in terms of notional value against RBC, alleging RBC conducted a massive wash trade scheme and made materially false and mislead Thomson Reuters

3 Futures & Derivatives Law Report May 2013 n Volume 33 n Issue 5 ing statements to the CFTC. 24 The CFTC alleged that RBC noncompetitively traded hundreds of millions of dollars in narrow-based stock index futures contracts and single stock futures contracts with two of its subsidiaries, where profits and losses of each RBC counterparty washed to zero through prearranged block trades. 25 The RBC counterparties allegedly entered into long and short positions in stocks in U.S. and Canadian companies and simultaneously entered into equal and offsetting positions in futures contracts written on the stocks. 26 The CFTC also alleged that from January 2005 to April 2010, RBC concealed material information and made false and misleading statements regarding the wash trades to OneChicago LLC, the electronic exchange on which the alleged wash scheme was conducted. 27 In February 2013, the CFTC actually sued one of the exchanges subject to its oversight. Specifically, the CFTC filed a complaint against NYMEX, operated by CME Group, and two former employees, alleging that over a several-year period, the two employees disclosed material nonpublic information to an outside commodity broker regarding customer trading on NYMEX, including specific order-related information and trading strategies of market participants. 28 The CFTC is seeking to hold NYMEX liable for allegedly not questioning the former employees or taking additional steps to determine whether the individuals were engaged in wrongful conduct after receiving a complaint from a market participant. 29 This case is apparently designed to put the exchanges on notice that the CFTC will police them vigorously in connection with the conduct of their own supervisory and self-regulatory responsibilities. A True Culture Shift The enforcement actions described above are strong evidence of a culture shift in CFTC enforcement. The CFTC has taken an increasingly prominent role in multiagency, cross-border enforcement actions that involve the commodities and derivatives markets. Indeed, in the LIBOR manipulation cases, the DOJ expressly acknowledged the CFTC s major role in these investigations and that the CFTC brought these matters to the DOJ s attention. 30 The CFTC began the LIBOR investigation in May 2008, the first agency to do so, and in early 2010, it began coordinating with the FSA. 31 Additional settlements from the LIBORrelated investigations are reportedly forthcoming in The CFTC is also postured for a lengthy, public litigation with the Royal Bank of Canada regarding the alleged wash trading scheme and has expanded its policing reach to the exchanges themselves with its recent complaint against NYMEX. Moreover, in addition to imposing record dollar figure sanctions, the CFTC has either required or effected substantial remedial measures and internal changes among market participants. In the LIBOR manipulation cases, for example, the CFTC required sweeping changes in policies and procedures associated with benchmark rate submissions by Barclays, UBS, and RBS, including requiring an audit of the submission process. 33 Other LIBOR panel banks are likely to implement these changes. As a result of the CFTC s focus on the proper segregation of customer funds, J.P. Morgan was required to institute comprehensive changes with respect to the maintenance and transfer of customer funds. 34 As is generally the case with government settlements, the remedial measures insisted upon are likely to become expected of other market participants and those participants will have to adapt accordingly. Not surprisingly, the CFTC is obtaining significantly higher penalties and appears to be using this tool as a deterrent against wrongful conduct. In its fiscal year ended September 30, 2012, the CFTC obtained orders imposing over $931 million in sanctions, including over $475 million in civil monetary penalties. 35 This amount represents a dramatic increase in monetary sanctions over fiscal year 2011, in which the CFTC obtained orders imposing approximately $450 million in sanctions, including $290 million in civil monetary penalties. 36 The trend in sizeable penalties appears to be developing into a strong enforcement tool flowing from the fact that the CFTC is taking an increasingly aggressive approach to regulating the massive over-the-counter derivatives market that has an estimated $300 trillion in notional value. 37 The CFTC has sought to demonstrate a quicker response time to detections of potential fraud in the market and to address issues of alleged misconduct with sweeping enforcement initiatives resulting in settlements against some of the largest and most prominent market participants. The CFTC still has not grown in size commensurate with the scope of the markets it regulates, 38 but it clearly appears to be devoting more of its limited enforcement 2013 thomson reuters

4 May 2013 n Volume 33 n Issue 5 Futures & Derivatives Law Report resources to higher profile matters. Large market participants should be on notice as the CFTC will be attempting to aggressively police its regulated entities and markets with a new standard of sanctions that aims to influence market behavior and deter wrongful conduct. END NOTES 1. Kevin J. Harnisch and David S. Mitchell are Partners of Fried, Frank, Harris, Shriver & Jacobson LLP and Andrew T. Smith is an Associate of the Firm. Kevin J. Harnisch is a partner in the Firm s Washington, DC office and concentrates his practice in the areas of securities enforcement defense, securities litigation and internal investigations. David S. Mitchell is a partner in the Firm s New York office and concentrates his practice in the areas of commodities, futures, and derivatives, including providing regulatory, transactional and litigation-related advice in connection with compliance and enforcement matters. 2. Javier E. David, Banks Must End Brazen, Flagrant Manipulation: CFTC s Chilton, CNBC.com (Feb. 6, 2013), Banks_Must_End_lsquoBrazen_Flagrantrsquo_ Manipulation_CFTCrsquos_Chilton. 3. Jenna Greene, CFTC Kicks Into High Gear, AmericanLawyer.com (Nov. 5, 2012), jsp?id= &thepage=2&slretu rn= ; U.S. CFTC breaks agency record for number of enforcement cases, Reuters.com (Feb. 6, 2013), com/article/2012/10/05/cftc-enforcementidusl1e8l54je It was recently reported that the CFTC has expanded its review of global financial benchmarks to include an examination of the setting of prices for gold and silver in London. Katy Burne, U.S. Probes Gold Pricing, WSJ.com (Mar. 13, 2013), html?KEYWORDS=cftc. 5. See Press Release, CFTC, CFTC Releases Enforcement Division s Annual Results (Oct. 5, 2012), cftc.gov/pressroom/pressreleases/pr In the Matter of Royal Bank of Scotland, plc, et al., Order, CFTC Docket at 4 (Feb. 6, 2013). 7. Id. Trimmed averaged rates, an average calculated by removing the highest and lowest rates, are then published by the BBA as the daily LIBOR rate, in addition to the daily submissions of each panel bank. Id. 8. Id. RBS was alleged to have violated Section 9(a) (2) of the Commodity Exchange Act ( CEA ) for making false submissions and Sections 6(c), 6(d), and 9(a)(2) of the CEA for attempted manipulation of LIBOR rates. Id. 9. Id. at Id. 11. Id. 12. Id. at See Press Release, CFTC, CFTC Orders The Royal Bank of Scotland plc and RBS Securities Japan Limited to Pay $325 Million Penalty to Settle Charges of Manipulation, Attempted Manipulation, and False Reporting of Yen and Swiss Franc LIBOR (Feb. 6, 2013), cftc.gov/pressroom/pressreleases/pr RBS entered into a deferred prosecution agreement with the DOJ and its Japanese subsidiary, RBS Securities Japan, pled guilty to wire fraud and manipulating Japanese Yen LIBOR. See Press Release, U.S. Dep t of Justice, RBS Securities Japan Limited Agrees to Plead Guilty in Connection with Long-Running Manipulation of Libor Benchmark Interest Rates (Feb. 6, 2013), opa/pr/2013/february/13-crm-161.html ( DOJ Release re: RBS settlement ). 14. In the Matter of UBS AG, et al., Order, CFTC Docket at 2 (Dec. 19, 2012). 15. Id. at Id. at In the Matter of Barclays PLC, et al., Order, CFTC Docket at 4 (Jun. 27, 2012). 18. See id. at 30, 31-42; In re UBS AG, et al., Order at 59, UBS and its Japanese entity settled charges with the DOJ, FSA (U.K.), and Swiss Financial Market Authority, agreeing to pay penalties of $500 million, $259.2 million (USD), and $64.3 million (USD), respectively. See Press Release, CFTC, CFTC Orders UBS to Pay $700 Million Penalty to Settle Charges of Manipulation, Attempted Manipulation and False Reporting of LIBOR and Other Benchmark Interest Rates (Dec. 19, 2012), pr UBS entered into a deferred prosecution agreement to settle charges with the DOJ and its Japanese subsidiary, UBS Securities Japan, pled guilty to wire fraud and manipulating Japanese Yen LIBOR. See Press Release, U.S. Dep t of Justice, UBS Securities Japan Co. Ltd. to Plead Guilty to Felony Wire Fraud for Long-running Manipulation of LIBOR Benchmark Interest Rates (Dec. 19, 2012), pr/2012/december/12-ag-1522.html ( DOJ Release re: UBS settlement ). Barclays settled charges with the DOJ and FSA (U.K.), agreeing to pay penalties of $160 million and $92.5 million (USD), respectively. See Press Release, CFTC, CFTC Orders Barclays to pay $200 Million Penalty for Attempted Manipulation of and False Reporting concerning LIBOR and Euribor Benchmark Interest Rates (Jun. 27, 2012), PressReleases/pr Barclays entered into an agreement with the DOJ in which it admitted and accepted responsibility for misconduct related to the manipulation of LIBOR and EURIBOR. See Press Release, U.S. Dep t of Justice, Barclays Bank PLC Admits Misconduct Related to Submissions for the London Interbank Offered Rate and the Euro Interbank Offered Rate and Agrees to Pay $160 Million Penalty (Jun. 27, 2012), gov/opa/pr/2012/june/12-crm-815.html ( DOJ Release re: Barclays settlement ) Thomson Reuters

5 Futures & Derivatives Law Report May 2013 n Volume 33 n Issue See supra note 5; In the Matter of J.P.Morgan Chase Bank, N.A., Commodity Futures Law Reporter (CCH) 32,156 (Apr. 4, 2012). 21. In re J.P. Morgan Chase Bank, N.A., supra note Id. 23. Id. 24. See CFTC v. Royal Bank of Canada, No. 12-Civ- 2497, Complaint (S.D.N.Y. Apr. 2, 2012). See also CFTC v. Royal Bank of Canada, No. 12-Civ-2497, Amended Complaint (S.D.N.Y. Oct. 17, 2012). 25. CFTC v. Royal Bank of Canada, Complaint at Id. 27. Id. at The complaint stated that RBC falsely disclosed to CME Group, a joint-owner of OneChicago which was conducting market surveillance on behalf of the exchange, that the wash sale trading was conducted at arm s length and also concealed the fact that the trading scheme was conducted by a group of senior RBC personnel. Id. at See also CFTC v. Royal Bank of Canada, Amended Complaint at See CFTC v. Byrnes, et al., No. 12-Civ-1174, Complaint (S.D.N.Y. Feb. 21, 2013). 29. Id. The CFTC s complaint alleged that the wrongful conduct continued after NYMEX received a complaint from a market participant. Id. at See DOJ Release re: RBS settlement, supra note 13; DOJ Release re: UBS settlement, supra note 19; DOJ Release re: Barclays settlement, supra note Brooke Masters, Concerns over Libor rate raised in 2007, FinancialTimes.com (Jul. 1, 2012), ad feabdc0.html#axzz2lycorbu9/. See also Chairman Gensler Testimony, opagensler-118 ( The CFTC initiated in April of 2008 a review of LIBOR after media reports raised questions about the integrity of the index. Thereafter, we began coordinating with the United Kingdom s Financial Services Authority (FSA), which helped us facilitate information requests. The FSA and the U.S. Department of Justice subsequently joined the CFTC with regard to the Barclays matter, and it has been a collaborative effort throughout. ). 32. Kristin Ridley, More Libor fines expected by midyear: source, Reuters.com (Feb. 8, 2013), See In re Barclays PLC, et al., Order at 31-42; In re UBS AG, et al., Order at 60-71; In re Royal Bank of Scotland, plc, et al., Order at In re J.P. Morgan Chase Bank, N.A., supra note See Press Release, CFTC, CFTC Releases Enforcement Division s Annual Results (Oct. 5, 2012). 36. Id. See also Press Release, CFTC, CFTC Releases Annual Enforcement Results (Oct. 6, 2011), pr See James Joyner, Derivatives Market 20 Times Size of American Economy, Asus.org (Jan. 13, 2010), derivatives-market-20-times-size-americaneconomy. 38. See Testimony of Gary Gensler, CFTC Chairman, before U.S. Senate Banking, Housing, and Urban Affairs Committee (Feb. 14, 2013), available at SpeechesTestimony/opagensler-131 ( At its FY 2012 staffing level of 710 FTEs, the agency is but 10 percent larger than our peak in the 1990s. ). Article REPRINT (#77345) Reprinted with permission from the May 2013 issue of The Futures & Derivatives Law Report West Services Inc., a Thomson Reuters company. All rights reserved. For more information about this publication please visit For more information about reprints from The Futures & Derivatives Law Report, visit PARS International Corp. at This PDF is authorized for electronic distribution and limited print distribution through June 20, 2014.