HEDGE FUND ADVISER CHARGED WITH BREACHING FIDUCIARY DUTY FOR ROLE IN CONFLICTED PERSONAL TRANSACTION

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION 
SEC Charges N.Y.-Based Hedge Fund Adviser With Breaching Fiduciary Duty By Participating in Conflicted Principal Transaction


2013-183 Washington D.C., Sept. 18, 2013 — The Securities and Exchange Commission charged the adviser to a New York-based hedge fund with breaching his fiduciary duty by engineering an undisclosed principal transaction in which he had a financial conflict of interest.

In a principal transaction, an adviser acting for its own account buys a security from a client account or sells a security to a client account.  Principal transactions can pose potential conflicts between the interests of the adviser and the client, and therefore advisers are required to disclose in writing any financial interest or conflicted role when advising a client on the other side of the trade.  They also must obtain the client’s consent.

The SEC alleges that Shadron L. Stastney, a partner at investment advisory firm Vicis Capital LLC, traded as a principal when he authorized the client hedge fund to pay approximately $7.5 million to purchase a basket of illiquid securities from a personal friend and outside business partner hired by the firm as a managing director.  Stastney required his friend to divest these personal securities holdings as he came on board at the firm because they overlapped with securities in which the hedge fund also was invested.  Stastney failed to tell the client hedge fund or any other partners and management at the firm that he had a financial stake in some of the same securities sold into the fund.  Stastney personally benefited and received a portion of the proceeds from the sale, and therefore was trading as a principal in the transaction.

Stastney agreed to pay more than $2.9 million to settle the SEC’s charges.

“Fund advisers cannot sit on both sides of a transaction as buyer and seller without the consent of the clients who rely on them for unbiased investment advice,” said Julie M. Riewe, Co-Chief of the SEC Enforcement Division’s Asset Management Unit.  “Stastney failed to live up to his fiduciary duty when he unilaterally set the terms of the transaction and authorized it without disclosing that he would personally profit from it.”

According to the SEC’s order instituting a settled administrative proceeding, in late December 2007 and early January 2008, Stastney arranged for his friend to sell the conflicted securities to the client hedge fund – Vicis Capital Master Fund – for $7.475 million.  Stastney’s friend informed him at the time that Stastney had a financial interest in some of the conflict securities, and Stastney would receive a portion of the sales proceeds.

The SEC’s order alleges that Stastney informed his two partners at the firm about the contemplated transaction, but never disclosed his personal financial interest in the transaction to them.  Stastney also did not disclose the conflict to the individual serving as the firm’s chief financial officer and chief compliance officer.  Moreover, Stastney failed to disclose to the trustee of the hedge fund that he had a personal financial interest in the transaction, and failed to obtain the client’s consent as required in a principal transaction.

According to the SEC’s order, after the hedge fund purchased the conflicted securities, Stastney’s friend wired Stastney’s share of more than $2 million of the sales proceeds to his personal savings bank account.

The SEC’s order requires Stastney, who lives in Marlboro, N.J., to pay disgorgement of $2,033,710.46, prejudgment interest of $501,385.06, and a penalty of $375,000.  Stastney also is barred from association with any investment company, investment adviser, broker, dealer, municipal securities dealer, or transfer agent for at least 18 months.  Stastney will be permitted to finish winding down the fund under the oversight of an independent monitor payable at his own expense.  Stastney has consented to the issuance of the order without admitting or denying any of the findings and has agreed to cease and desist from committing or causing any violations and any future violations of Sections 206(2) and 206(3) of the Investment Advisers Act of 1940.

The SEC’s investigation was conducted by Vincenzo A. DeLeo and Brian E. Fitzpatrick of the Asset Management Unit with the assistance of James Flynn, Alistaire Bambach, and Nancy A. Brown in the New York Regional Office.  The case was supervised by Sharon B. Binger.  The investigation began following an examination of the firm by Jennifer M. Klein, Arthur Schmidt, and Belinda L. Rodriquez under the supervision of Dawn M. Blakenship.

SEC ANNOUNCES CHARGES AGAINST 10 FORMER BROKERS IN $125 MILLION INVESTMENT SCHEME

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION 

The Securities and Exchange Commission today announced charges against 10 former brokers at an Albany, N.Y.-based firm at the center of a $125 million investment scheme for which the co-owners have received jail sentences.

The SEC filed an emergency action in 2010 to halt the scheme at McGinn Smith & Co. and freeze the assets of the firm and its owners Timothy M. McGinn and David L. Smith, who were later charged criminally by the U.S. Attorney’s Office for the Northern District of New York and found guilty.

The SEC’s Enforcement Division alleges that 10 brokers who recommended the unregistered investment products involved in the scheme made material misrepresentations and omissions to their customers.  The registered representatives ignored red flags that should have led them to conduct more due diligence into the securities they were recommending to their customers.

“As securities professionals, these brokers had an important duty to determine whether the securities they recommended to customers were suitable, especially when red flags were apparent.  These registered representatives performed inadequate due diligence and failed to fulfill their duties,” said Andrew M. Calamari, Director of the SEC’s New York Regional Office.

The SEC’s order names 10 former McGinn Smith brokers in the administrative proceeding:

Donald J. Anthony, Jr. of Loudonville, N.Y.
Frank H. Chiappone of Clifton Park, NY.
Richard D. Feldmann of Delmar, N.Y.
William P. Gamello of Rexford, N.Y.
Andrew G. Guzzetti of Saratoga Springs, N.Y.
William F. Lex of Phoenixville, Pa.
Thomas E. Livingston of Slingerlands, N.Y.
Brian T. Mayer of Princeton, N.J.
Philip S. Rabinovich of Roslyn, N.Y.
Ryan C. Rogers of East Northport, N.Y.
According to the SEC’s order, the scheme victimized approximately 750 investors and led to $80 million in investor losses.  Guzzetti was the managing director of McGinn Smith’s private client group from 2004 to 2009, and he supervised brokers who recommended the firm’s offerings.  The SEC’s Enforcement Division alleges that despite his knowledge of serious red flags, Guzzetti failed to take any action to investigate the offerings and instead encouraged the brokers to sell the notes to McGinn Smith customers.

The SEC’s Enforcement Division alleges that the other nine brokers charged in the administrative proceeding should have conducted a searching inquiry prior to recommending the products to their customers.  The brokers continued to sell McGinn Smith notes even after being told that customers placed in some of the firm’s offerings could only be redeemed if a replacement customer was found.  This was contrary to the offering documents.  In January 2008, the brokers learned that four earlier offerings that raised almost $90 million had defaulted, yet they failed to conduct any inquiry into subsequent offerings and continued to recommend McGinn Smith notes.

The SEC’s order alleges that the misconduct of Anthony, Chiappone, Feldmann, Gamello, Lex, Livingston, Mayer, Rabinovich, and Rogers resulted in violations of Sections 5(a), 5(c), and 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5.  The order alleges that Guzzetti failed to reasonably supervise the nine brokers, giving rise to liability under Section 15(b)(6) of the Exchange Act, incorporating by reference Section 15(b)(4).

The SEC’s civil case continues against the firm as well as McGinn and Smith, who were sentenced to 15 and 10 years imprisonment respectively in the criminal case.
The SEC’s investigation was conducted by David Stoelting, Kevin P. McGrath, Lara Shalov Mehraban, Haimavathi V. Marlier, Joshua Newville, Kerri Palen, Michael Paley, and Roseann Daniello of the New York office.  Mr. Stoelting, Ms. Marlier and Michael Birnbaum will lead the Enforcement Division’s litigation.

Deploying the Full Enforcement Arsenal

Deploying the Full Enforcement Arsenal

ADDRESS BY CFTC COMMISSIONER O'MALIA AT GLOBAL FORUM FOR DERIVATIVES MARKETS

FROM:  COMMODITY FUTURES TRADING COMMISSION 
Regulatory Harmonization, Not Imperialism: A Workable Cross-Border Framework

Keynote Address By Commissioner Scott D. O’Malia, The Global Forum for Derivatives Markets (34th Annual Burgenstock Conference), Geneva, Switzerland

September 26, 2013

Thank you very much for the kind introduction and for inviting me to speak here today.

These certainly are fascinating times in the world of derivatives, and it’s good to see so many people gathered here to discuss and debate the numerous pressing issues facing the industry today.

I would like to thank all of the regulators that took part in yesterday’s discussions regarding the status of the global regulatory framework. Yesterday’s meeting builds on last week’s IOSCO board meeting, which I attended and participated in. I have benefitted from both bilateral and multilateral discussions. Both the message and the goals are of my fellow regulators are clear. We must harmonize our rules to prevent regulatory arbitrage from undermining our comprehensive financial reforms.

Speaking of financial reforms, as you may have noticed, the Commission has been nothing if not busy the past three years. It has been working at a feverish – and sometimes too hurried – pace to implement the Dodd-Frank legislation. To date, the Commission has issued 61 final rules, orders and guidance documents. We have also issued over 100 exemptions and no-action letters – some for an indefinite time – from the very rules we just passed.

Today, I would like to focus on three topics. First, the cross-border regulatory framework. Second, the landscape for swap execution facilities (“SEFs”). And third, upcoming Commission rules on customer protection and position limits.

Cross-Border Framework: Regulatory Harmonization, Not Imperialism

Let me start with my first topic: cross-border issues. Right now we are at a critical juncture in global regulators’ efforts to establish a cross-border regulatory framework for derivatives. Before I get to my thoughts on what must be done in order to ensure an effective, efficient and workable framework, let’s review what has already taken place.

The Commission finalized its cross-border guidance on July 12.1 I had many serious concerns about the document that prevented me from supporting its approval. Let me briefly share a few of these concerns. First, the guidance failed to justify its overbroad extraterritorial reach under the statute’s “direct and significant” standard. This standard was in fact meant to be a limitation on the Commission’s authority, not an invitation to bring the world under the Commission’s jurisdiction.

Second, in staking out such an overbroad position, the guidance failed to give sufficient consideration to principles of international comity.

Third, the Commission should have issued the document as a rulemaking, not as an “interpretive guidance.” That may sound like a trivial distinction, but it is not.

A Commission interpretative guidance document does not have the force of law, in contrast to a Commission rule. Yet this guidance imposes obligations that have a practical binding effect, and market participants cannot afford to ignore these obligations for fear of enforcement or other penalizing action.

The issuance of interpretative guidance instead of a rulemaking had other negative consequences. It allowed the Commission to avoid a proper cost-benefit analysis. In addition, it allowed the Commission to avoid the requirements of the Administrative Procedure Act (“APA”), which was enacted by Congress to ensure fair notice, public participation, and reasoned decision-making and accountability in connection with agency action.

Fourth, and most relevant for our discussion here today, the Commission got the process and order of things all wrong. In finalizing the guidance, it made a preemptive unilateral move that only made more difficult the task of reaching a harmonized global framework with its fellow regulators – imperialist regulation, in other words. What the Commission should have done is the opposite: settle on a framework with international regulators, and then finalize its policy.

Substituted Compliance: Sunlight Is the Best Disinfectant

As the saying goes, “sunlight is the best disinfectant.” And I believe that holds true for the Commission’s substituted compliance process. It was and remains my hope that the previous policy overreach that occurred through the expansive cross-border guidance can be mitigated through a transparent, structured, and consistent process for the Commission’s substituted compliance determinations, a crucial element of the harmonization effort.

As part of such a process, I have emphasized the importance of offering the opportunity for other regulatory bodies to engage directly with the full Commission. This would allow us to better understand how our rules and theirs will work and to minimize the likelihood of regulatory retaliation and inconsistent, duplicative, or conflicting rules.

I have been doing my best to facilitate interaction and dialogue between the Commission and fellow regulators. As I mentioned, last week I attended IOSCO’s annual conference in Luxembourg. There, I participated in the board’s sessions and had productive discussions with regulators from the jurisdictions that have applied, or are planning to apply, for substituted compliance.

Nevertheless, thus far the process for substituted compliance determinations has not been transparent enough. By way of analogy, it suffers from many of the same shortcomings as the concerns with the development of an index developed by a price reporting agency. Both are opaque and one never knows exactly how the methodology is applied.

It’s time to take the process out of the dark, and explain to the rest of the Commission and the applicants how these evaluations will be conducted.

Supervisory MOUs: The Flexible Complement to Substituted Compliance

Besides substituted compliance determinations, there is another important element to the cross-border regulatory framework: supervisory memoranda of understanding (“MOUs”) between the Commission and fellow regulators. These MOUs, if done right, can be a key part of the global harmonization effort.

The reason for this is that the substituted compliance regime cannot, by itself, solve the cross-border puzzle. What substituted compliance will do is to provide a clear understanding of similarities and differences between jurisdictions. What it won’t do – especially because the determinations are to be made by the end of this year, and the rulemaking process is ongoing and fluid in a number of places – is provide the necessary flexibility to fill in any gaps. The MOUs provide this flexibility.

Because the MOUs are so complementary to substituted compliance, the Commission should be able to review them alongside the respective substituted compliance determinations and vote on them at the same time.

Dictating to the rest of the world a one-size-fits-all regulatory standard will not yield long-term regulatory cooperation. While it is important that regulators identify where there are differences in our regulatory regimes, we must also have a mutually agreed upon solution for resolving our differences through bilateral supervisory agreements.

SEFs: To Foster the Landscape, the Commission Must Be Flexible

Now, I would like to move to my second topic: SEFs. We are less than 10 days away from SEFs going live on October 2. As of today, Commission staff has temporarily registered 15 SEFs and has to review four more applications before October 2.

I am very optimistic about the potential SEF platforms and the innovative trading opportunities they can provide. Not only will markets benefit from increased standardization and improved liquidity, but I will be interested to see how the swap/futures trading relationship evolves as a result of these platforms.

On September 12, I chaired a Technology Advisory Committee (“TAC”) meeting where the Commission had an opportunity to hear concerns from different market participants, including SEFs, dealers, and clearing members, regarding the implementation of various regulatory requirements.

Given the concerns raised by market participants, it would make sense to delay the October 2 compliance date, especially because this date is an arbitrary date and is not tied to any legal requirements. Market participants would benefit from getting a time-limited extension to allow for a smooth transition to these new execution venues. If the Commission wants to foster a robust, competitive landscape for SEFs, it must be flexible enough to adjust the compliance date based on market and technology realities, and not stick with an unworkable date simply to adhere to an individual agenda.

A number of TAC panelists raised concerns about various onboarding issues. It was clear from the discussions that market participants need more time to review SEF rule books and participant agreements for consistency and legal compliance. Frankly, I don’t blame them for being extra careful, given the fact that Commission staff publicly announced that it is not going to review SEF applications for substantive compliance.

Another troublesome issue that was brought up during the TAC meeting involves notorious Footnote 88 in the SEF final rules.

The rules require existing multiple-to-multiple swap trading venues to register as SEFs, even if they only offer products that are not yet subject to the trade execution mandate. This has resulted in venues offering products like non-deliverable forwards and foreign exchange options to rush to get registration applications completed on time.

However, Footnote 88 allows other platforms, such as single dealer platforms, to continue trading swaps not subject to the trade execution mandate and without having to register with the Commission.

Another issue that causes a lot of anxiety among SEFs is the requirement to report permitted transactions (i.e. transactions that are not subject to the trade execution mandate) to a swap data repository (“SDR”).

Based on the proposed rules, SEFs did not anticipate that the Commission would require these transactions to be executed on a SEF. Thus, SEFs do not have sufficient time to build the technology infrastructure for the reporting of these transactions.

Many of these permitted transactions are not electronically executed and are, by nature, less standardized than required transactions. Thus, from a technology perspective, SEFs are concerned that the trade reporting mechanisms will simply not be in place by October 2.

Our track record on utilizing and analyzing data has not been good and the Commission struggles to effectively understand and organize SDR data. The last thing we can afford is to implement an untested and unprepared reporting system based on an arbitrary date.

Market participants are also concerned about Commission staff’s sudden announcement via an email message that SEFs are required to provide for pre-execution credit checks.

Without certainty of clearing at the point of execution, counterparties are exposed to the potentially significant costs of a trade failure. Some type of pre-trade credit-checking is necessary to ensure that clearing members will extend sufficient credit. This is a policy that I support.

However, since neither the SEF proposed rule nor the final rule addressed this requirement, market participants are scrambling to understand the requirement and the pros and cons of various technology models that could be utilized to set these credit limits.

First, the Commission must be clear about its expectations regarding guarantee arrangements and what the market should do if a trade is broken because of credit issues. Second, if these expectations require additional technology investments, I believe that the Commission needs to give industry more time to build the necessary technology infrastructure as well as to iron out various workflow issues.

Last but not least, the Commission is facing serious problems regarding its treatment of EU-regulated multilateral trading facilities (“MTFs”). In the Barnier-Gensler “Path Forward” document,2 the Commission assured European regulators that it will extend appropriate time-limited transitional relief to certain EU-regulated MTFs, in the event that the Commission’s trade execution requirement is triggered before March 15, 2014.

However, the flexibility embodied in this agreement appears to be in direct contradiction to the SEF final rules that expressly require all platforms meeting a SEF definition to register by October 2, or cease operation. I don’t think the current registration requirement on October 2 is consistent with either the spirit or the letter of the “Path Forward” document. It is unclear to me what the impact on liquidity will be if as a result of this problem, all U.S. persons are required to trade exclusively on U.S. SEF platforms or else to be forced to revert to bilateral trading.

Upcoming Rules: Customer Protection and Position Limits

My third and final topic is to share some of my thoughts on two important rules currently being considered by the Commission.

One is a final rule on enhanced customer protection measures. In the wake of the major failures of MF Global and Peregrine Financial, the Commission and the industry are looking carefully at ways to make enhancements to customer protection.

One improvement already in place is an electronic customer funds confirmation network that will confirm the customer balances held at FCMs and custodian banks. This initiative, funded entirely by the industry, was first contemplated at an emergency TAC meeting I convened in July 2012 to discuss customer protection. Its operation today will ensure that customer funds can’t be used for unauthorized purposes.

Currently before the Commission is a draft final rule to make various reforms to accounting standards, reporting requirements and a controversial new provision requiring FCMs to maintain enough residual interest in their segregated customer accounts in an amount that would ensure that at no point does one customer’s funds margin or extend credit to another customer.

Residual Interest: A Change of Interpretation

This proposal has been met with great concern across the entire industry, in large part because the proposal is at odds with the Commission’s long-held interpretations spanning the past 50 years. Historically the Commission has allowed FCMs to meet their residual interest requirement by maintaining additional funds in an amount equal to the net margin deficit the FCM predicted for its segregated account. This calculation was required to be made once a day, not in real time.3

With the Commission’s reinterpretation, FCMs would be required to change their practices to hold enough residual interest to make up for the margin deficiency of all customers at all times on a gross basis. This means that a firm would be required to calculate the potential margin deficit for each customer throughout the trading day and set aside an amount equal to that estimated deficit so that no customer’s margin excess is used to margin the position of another customer.

If the Commission maintains its original standard of compliance “at all times,” we will have an enormous increase in the capital required to participate in these markets. According to a review conducted by FIA, this new residual interest rule will require clearing members on U.S. futures exchanges, and most likely their customers, to put up an additional $100 billion in order to meet the requirement.4

I have heard from a large number of agricultural interests – farmers, ranchers and many smaller FCMs who serve these customers – that believe this provision will raise their costs significantly. Commercial firms who would be most impacted by this policy change have indicated they aren’t able to shift funds like large commercial banks and need flexibility to make their margin payments to the FCM.

If, on the other hand, the Commission moves away from the “at all times” standard, we would have to articulate how a margin calculation done at any other time interval satisfies the supposed statutory requirements of requiring margin “at all times.”

Weak Cost-Benefit Analysis

I think we must also look at this residual interest issue in the context of the cost-benefit analysis. As you know, I have frequently cited the Commission’s cost-benefit analysis as a source of weakness when the agency justifies the imposition of a new regulatory requirement on the industry. Unfortunately I think the same criticism can be made here.

The Commission’s proposal does acknowledge that it is very likely that FCMs will pass along the additional cost of compliance to their customers. However, it makes no effort to quantify the cost borne by those customers, or to link that cost directly to the actual risk those customers introduce into the derivatives markets.

I appreciate the fact the rule change is intended to increase protection for customer funds. But, when the rules propose reforms that significantly increase the cost to a point that it becomes uneconomic to hedge, it is hard to argue that we are protecting customers.

This is why I believe it is so important the Commission quantify the cost versus the benefits. We also need to take a clear look at what actual protection this change will provide based on past practice. I believe through improved surveillance and the use of technology to monitor customer flows, we can make improvements to current practice and still provide the flexibility to commercial firms to make timely margin payments, without imposing unreasonable costs.

Position Limits

The Commission is also considering a new proposed rule on position limits. As a preliminary matter, I question the unsavory maneuver of proposing a new rule while simultaneously continuing to argue in the courts that the original, vacated rule was valid. Putting that aside, I will focus mainly on a few key areas as I consider the new proposal.

First, statutory justification: the Commission must do the necessary homework it failed to do in the vacated rule in order to justify establishing any limits. Second, bona fide hedging: the Commission must articulate a definition of hedging that reflects the realities of how commercial firms use the derivatives markets to manage risk, in order for these activities to be exempted from any limits. And third, aggregation of positions: the Commission’s aggregation policy must be reasonable in principle, and it must be workable in practice given complicating factors such as complex corporate structures and relationships as well as laws that prohibit information-sharing.

Conclusion

I would like to conclude today by returning to my first topic: the cross-border framework. Today’s derivatives markets are undoubtedly global and highly interconnected. Just as we must accept this reality, we must also accept that the Commission is not the global regulatory authority. It simply cannot be, not least because of resource limitations – but more than that, it should not want to be.

The only workable and effective way to regulate these markets is for regulators to work together and establish a harmonized framework that avoids overreach, duplication, inconsistency, and conflict. To achieve this, the Commission must implement a transparent process for substituted compliance. This process must include active engagement with fellow regulators. And the Commission must complement this substituted compliance regime with a set of flexible MOUs. If it does these things, the Commission can rightly take credit for choosing the path of regulatory harmonization over the path of regulatory imperialism.

Thank you very much for your time.

1 http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2013-17958a.pdf.

2 http://www.cftc.gov/PressRoom/PressReleases/pr6640-13.

3 See 17 CFR §1.32, which calls for an FCM to compute at the close of each business day the total amount of futures customer funds on deposit in segregated accounts, the amount of futures customer funds required under the Commodity Exchange Act and Commission regulations to be on deposit, and the amount of the FCM’s residual interest in customer funds.

4 See FIA comment letter dated February 15, 2013, available at http://www.futuresindustry.org/downloads/Enhanced_Customer_Protection_021513.pdf.

CFTC ORDERS NEWBRIDGE METALS TO PAY RESTITUTION FOR ILLEGAL PRECIOU METALS TRANSACTIONS

FROM:  COMMODITY FUTURES TRADING COMMISSION 
CFTC Orders Florida Company Newbridge Metals, LLC to Pay over $1.5 Million in Restitution for Illegal, Off-Exchange Precious Metals Transactions

Washington, DC – The U.S. Commodity Futures Trading Commission (CFTC) today issued an Order filing and simultaneously settling charges against Newbridge Metals, LLC, based in Boca Raton, Florida, for engaging in illegal off-exchange precious metals transactions.

The CFTC Order requires Newbridge to pay restitution of $1,517,930.66 to its customers. In addition, the Order imposes permanent registration and trading bans against Newbridge and requires the firm to cease and desist from violating Section 4(a) of the Commodity Exchange Act, as charged.

As explained in the Order, financed transactions in commodities with retail customers, like those engaged in by Newbridge, must be executed on, or subject to, the rules of an exchange approved by the CFTC.  The CFTC Order finds that, from February 2012 through February 2013, Newbridge solicited retail customers to buy and sell precious metals on a financed basis.

According to the Order, Newbridge telemarketers typically represented that a customer could purchase a desired quantity of precious metals with a 25% deposit, and that the customer could borrow the remaining 75%. The customer would then pay Newbridge a finance charge on the loan, a service charge, and a maximum commission of 15%.

If a customer agreed to the transaction, the customer sent the deposit, finance charge, and commission to Newbridge. Newbridge confirmed the transaction and ultimately transferred the funds to Hunter Wise Commodities, LLC (Hunter Wise), the Order finds.  Hunter Wise subsequently remitted to Newbridge a portion of the customer commissions and fees, with Newbridge ultimately receiving $1,517,930.66 in commissions and fees for the retail financed precious metals transactions executed through Hunter Wise, the Order states.

However, according to the Order, neither Newbridge nor Hunter Wise bought, sold, loaned, stored, or transferred any physical metals for these transactions, and neither company actually delivered any precious metals to any customer.  Because Newbridge’s transactions were executed off exchange, they were illegal.

The CFTC sued Newbridge’s clearing firm, Hunter Wise, in federal court in Florida on December 5, 2012.  The CFTC charged Hunter Wise with engaging in illegal, off-exchange precious metals transactions, as well as fraud and other violations (see CFTC Press Release 6447-12).  On February 25, 2013, the court granted a preliminary injunction against Hunter Wise, froze the firm’s assets, and appointed a corporate monitor to assume control over those assets (see CFTC Press Release 6522-13).

ATLANTA-AREA DEFENDANTS CHARGED BY SEC WITH SECURITIES FRAUD

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION 
SEC Charges Atlanta-Area Defendants with Securities Fraud

On September 23, 2013, the Securities and Exchange Commission filed an action in federal court in the Northern District of Georgia, charging Stephen L. Kirkland (Kirkland), a Marietta, Georgia resident, and his company The Kirkland Organization, Inc. (TKO), a Georgia corporation, with violations of the federal securities laws for making false and misleading statements to investors in the United States and in Great Britain.  The Commission’s complaint seeks permanent injunctions, disgorgement of ill-gotten gains with prejudgment interest, and civil penalties against the defendants.

The Commission’s complaint alleges that between late 2008 and late 2010, Kirkland and TKO repeatedly made false and misleading statements to investors and potential investors including but not limited to: (a) if they invested with the defendants through a managed account at Westover Energy Trading Partners, LLC (Westover), there would be no risk of losing their principal; (b) they would earn 2% to 3% per month; (c) a specified New York real estate developer/owner was a manager of Westover; and (d) the New York real estate developer/owner’s substantial wealth would be used to indemnify investors against loss.  Investors in the United States and Great Britain have invested at least $800,000 with the defendants based upon those false representations.

The complaint alleges that Kirkland and TKO violated the antifraud provisions of the federal securities laws, Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and Rule 10b-5 thereunder.  It further alleges that while acting as investment advisors, the Defendants violated Sections 206 (1) and Section 206 (2) of the Investment Advisers Act of 1940 (“Advisers Act”), the antifraud provisions of the Advisers Act.  With respect to Kirkland, the complaint also alleges that he, while acting as a control person, induced violations of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder.

SEC CHARGES OWNERS OF TWO COMPANIES WITH DEFRAUDING INVESTORS IN OIL AND GAS OFFERINGS

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION 

The Securities and Exchange Commission today charged the owner of two Florida-based companies with defrauding investors in five oil and gas offerings by misrepresenting such key facts as the amount of available reserves, the use of investor funds, and his past success in the oil and gas industry.

The SEC alleges that Ronald Walblay of Delray Beach, Fla., perpetrated the fraud through RyHolland Fielder Inc., which has managed a number of oil and gas limited partnerships, and his former brokerage firm Energy Securities Inc., which sold the partnerships’ interests – none of which were registered with the SEC as required under the federal securities laws. Walblay raised at least $12 million from more than 195 U.S. and foreign investors by falsely touting in sales brochures that RyHolland Fielder offered millions of barrels of oil and natural gas reserves. Walblay also falsely touted in offering materials that investors could receive potential returns of up to 2,270 percent. Meanwhile, not a single investor had ever profited from any of the partnerships, and Walblay used a greater percentage of investor funds than was disclosed to pay salaries and marketing expenses for investor conferences.

According to the SEC’s complaint filed in U.S. District Court for the Southern District of Florida, the unregistered securities offerings by Walblay and his firms were in Basin Oil L.P., Basin Oil HV L.P., Great Plains Oil L.P., Permian Basin Oil L.P., and Texas Permian Oil LLLP. They solicited investors from approximately January 2009 to November 2012.

The SEC alleges that in some offerings Walblay falsely portrayed to investors that RyHolland Fielder offered billions of cubic feet of natural gas reserves in place. Walblay, Energy Securities, and RyHolland lacked any basis to make this statement to investors because no such reserves existed.

The SEC further alleges that the offering materials for the limited partnerships misled investors about the use of proceeds. For example, contrary to the statements made in documents distributed to investors, money raised from investors in the Permian Basin Oil L.P. offering were partly used to pay expenses incurred in the prior oil and gas offerings.

According to the SEC’s complaint, Walblay exaggerated his past success in the industry.  For instance, he told investors that a prior offering he conducted in 1991 featured a well that produced more than 100,000 barrels of oil in less than 45 days.  There was no basis to make this statement.

The SEC’s complaint charges Energy Securities, RyHolland, and Walblay with violating Sections 5(a) and (c) and 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5. The complaint also charges Walblay with aiding and abetting violations of Section 10(b) of the Exchange Act and Rule 10b-5. The SEC seeks financial penalties, disgorgement of ill-gotten gains with prejudgment interest, and permanent injunctions.

CFTC CLOSES SILVER CONTRACT MARKET MANIPULATION CASE

FROM:  COMMODITY FUTURES TRADING COMMISSION
CFTC Closes Investigation Concerning the Silver Markets

Washington, DC – The Commodity Futures Trading Commission (CFTC or Commission) Division of Enforcement has closed the investigation that was publicly confirmed in September 2008 concerning silver markets. The Division of Enforcement is not recommending charges to the Commission in that investigation. For law enforcement and confidentiality reasons, the CFTC only rarely comments publicly on whether it has opened or closed any particular investigation. Nonetheless, given that this particular investigation was confirmed in September 2008, the CFTC deemed it appropriate to inform the public that the investigation is no longer ongoing. Based upon the law and evidence as they exist at this time, there is not a viable basis to bring an enforcement action with respect to any firm or its employees related to our investigation of silver markets.

In September 2008 the CFTC confirmed that its Division of Enforcement was investigating complaints of misconduct in the silver market (see CFTC Release 5562-08, October 2, 2008). At that time the Commission had received complaints regarding silver prices. These complaints were focused on whether the silver futures contracts traded on the Commodity Exchange, Inc. (COMEX) were being manipulated.1 For example, the complaints pointed to differences between prices in the silver futures contracts and prices in other silver products, including retail silver products. The complainants generally asserted that because the prices for retail silver products, such as coins and bullion, had increased, the price of silver futures contracts should have also experienced an increase. By reference to publicly available information concerning large traders with short open positions in the silver futures contracts, the complaints also alleged that the large shorts in the silver market were responsible for lower futures prices. The Division of Enforcement conducted an exhaustive investigation of these and other complaints and focused on identifying and evaluating whether there was any trading activity in violation of the Commodity Exchange Act and Commission regulations including the anti-manipulation provisions.

The Division of Enforcement’s investigation utilized more than seven thousand enforcement staff hours. The staff reviewed and analyzed position and transaction data, including physical, swaps, options, and futures trading data, and other documents and information, and interviewed witnesses. The Division’s investigation included an evaluation of silver market fundamentals and trading within and between cash, futures and over the counter markets. The investigation was also undertaken with assistance by the Commission’s Division of Market Oversight, the Commission’s Office of Chief Economist, and outside experts.

Separately, the Division of Market Oversight continued surveillance of the silver market contemporaneously to the Division of Enforcement’s investigation. The Division of Market Oversight’s market surveillance function encompasses a robust monitoring of traders’ positions and transactions at the ownership and account levels to identify potential violations of the Commodity Exchange Act and Commission regulations including, but not limited to, price manipulation, disruptive trading and trade practice violations. For example, after an episode of sharp price moves in any commodity, staff utilizes numerous visualization and analytical tools on data submitted daily to the Commission to discover indications of potential manipulation and other violations. Where questions remain, Division of Market Oversight staff regularly utilize the Commission authority such as the Special Call under Regulation § 18.05 to obtain additional detailed information from traders.

The Division of Enforcement takes complaints it receives seriously. The Division will not hesitate to use its authority, including new manipulation authority in the Dodd-Frank Act, to bring market manipulation charges as supported by the evidence.

If you have information about a violation of the Commodity Exchange Act or Commission regulations, you may either file a tip or complaint under our whistleblower program, or report such violations or other suspicious activities or transactions to our Division of Enforcement. The CFTC will pay awards to eligible whistleblowers who voluntarily provide us with original information about violations of the Commodity Exchange Act that lead us to bring an enforcement action that results in more than $1 million in monetary sanctions.

1 The CME Group now includes the New York Mercantile Exchange (NYMEX) as well as the Commodity Exchange, Inc. (COMEX).  Market participants generally still refer to the silver futures contracts offered by the CME Group as “COMEX silver futures.”

ICAP EUROPE LIMITED CHARGED BY SEC WITH ATTEMPTED MANIPULATION OF YEN LIBOR

FROM:   COMMODITY FUTURES TRADING COMMISSION 
CFTC Charges ICAP Europe Limited, a Subsidiary of ICAP plc, with Manipulation and Attempted Manipulation of Yen Libor
ICAP Europe Limited Ordered to Pay a $65 Million Civil Monetary Penalty

Washington, DC -- The U.S. Commodity Futures Trading Commission (CFTC) today issued an Order against ICAP Europe Limited (ICAP), an interdealer broker, bringing and settling charges of manipulation, attempted manipulation, false reporting, and aiding and abetting derivatives traders’ manipulation and attempted manipulation, relating to the London Interbank Offered Rate (LIBOR) for Yen. LIBOR is a critical benchmark interest rate used throughout the world as the basis for trillions of dollars of transactions. ICAP is a subsidiary of U.K.-based ICAP plc.

The CFTC’s Order finds that for more than four years, from at least October 2006 through at least January 2011, ICAP brokers on its Yen derivatives and cash desks knowingly disseminated false and misleading information concerning Yen borrowing rates to market participants in attempts to manipulate, at times successfully, the official fixing of the daily Yen LIBOR. ICAP brokers, including one known as “Lord LIBOR” or “Mr. LIBOR,” did so to aid and abet their highly valued client, who was a senior Yen derivatives trader (Senior Yen Trader) employed at UBS Securities Japan Co., Ltd. (UBS) and later at another bank, in his relentless attempts to manipulate Yen LIBOR to benefit his derivatives trading positions tied to this benchmark. On limited occasions, ICAP Yen brokers engaged in this unlawful conduct to benefit other derivatives traders as well. (See excerpts of relevant broker communications as a Related Link.)

The Order requires ICAP, among other things, to pay a $65 million civil monetary penalty, and cease and desist from further violations as charged. Pursuant to the Order, ICAP and ICAP plc also agree to take specified steps to ensure the integrity and reliability of benchmark interest rate-related market information disseminated by ICAP and certain other ICAP plc companies.

“ICAP and other interdealer brokers are expected to be honest middlemen,” said David Meister, the CFTC’s Director of Enforcement. “Here, certain ICAP brokers were anything but honest. They repeatedly abused their trusted role when they infected the financial markets with false information to aid their top client’s manipulation of LIBOR. As should be clear from today’s action, any market participant who seeks to undermine the integrity of a global benchmark interest rate must be held accountable.”

Yen LIBOR is fixed daily based on rates contributed by panel banks for Yen LIBOR that are supposed to reflect each bank’s assessment of costs of borrowing unsecured funds in the London interbank market. ICAP, as an interdealer broker, intermediates cash and LIBOR-based derivatives transactions between banks and other institutions. As a service to clients and to solicit and maintain business, ICAP also provides banks with market insight, including projections of likely LIBOR fixings, which are implicitly represented as ICAP’s unbiased assessment of borrowing costs and market pricing based on objective, observable data, some of which was uniquely in ICAP’s possession.

According to the CFTC’s Order, the UBS Senior Yen Trader called on ICAP Yen brokers more than 400 times for assistance in manipulating Yen LIBOR. ICAP brokers often accommodated the requests by issuing, via a Yen cash broker, group emails to panel banks and others containing “Suggested LIBORs” for Yen LIBOR. But rather than providing an honest and objective assessment of how Yen LIBOR would fix, the Suggested LIBORs reflected the preferred rates that would benefit the Senior Yen Trader.

The Order finds that almost all of the Yen LIBOR panel banks received the Suggested LIBORs, and several relied on them in making their Yen LIBOR submissions, particularly during the financial crisis of 2007-2009. Even panel banks that tried to make truthful Yen LIBOR submissions may have passed on false or misleading submissions, because they used ICAP brokers’ purportedly unbiased Suggested LIBORs to inform their LIBOR submissions.

According to the Order, the ICAP brokers referred to the panel bank submitters as “sheep” when they copied the Yen cash broker’s Suggested LIBORS. In fact, the Order finds that at least two banks’ submissions mirrored the Suggested LIBORs up to 90% of the time.

The Order further finds that the ICAP Yen Brokers provided these “LIBOR services” to keep the Senior Yen Trader’s business, which accounted for as much as 20% of the Yen derivatives desk’s revenue. “Mr. LIBOR,” the Yen cash broker who disseminated the false Suggested LIBORs, demanded compensation from the Yen derivatives desk for his “LIBOR services” or “no more mr libor.” This grew from dinners and champagne, to additional commission-generating trades, to “kick backs” totaling $72,000.

The Order further finds that this unlawful, manipulative conduct continued for more than four years, in part because ICAP’s supervision, internal controls, policies and procedures were inadequate. For example, ICAP never audited the Yen derivatives desk and left compliance oversight to the Yen derivatives desk head, who was complicit in the misconduct.

ICAP plc and ICAP Must Strengthen Internal Controls to Ensure Integrity and Reliability of Benchmark Interest Rate-Related Market Information

In addition to imposing a $65 million penalty, the CFTC Order requires ICAP and ICAP plc to implement and strengthen internal controls, policies and procedures governing benchmark interest rate-related market information that ICAP and certain ICAP plc companies send to market participants. Among other things, the Order requires ICAP and ICAP plc to:

• Base written benchmark interest rate-related predictions on certain factors;

• Document and retain basis for market publications;

• Require certain disclosures, including that certain market information reflects the opinions of the author, sources of information or data upon which opinion is based; and use of any models, correlated markets or related trading instruments;

• Review certain electronic and audio communications;

• Implement auditing, monitoring and training measures;

• Report to the CFTC on its compliance with the terms of the Order; and

• Continue to cooperate with the CFTC

The CFTC Order also recognizes the cooperation of ICAP Europe Limited with the Division of Enforcement in its investigation.

In a related action, the United Kingdom Financial Conduct Authority (FCA) issued a Final Notice regarding its enforcement action against ICAP Europe Limited and imposed a penalty of £14 million, the equivalent of approximately $22.4 million.

The CFTC acknowledges the valuable assistance of the FCA, the U.S. Department of Justice and the Washington Field Office of the Federal Bureau of Investigation.

*******

With this Order, the CFTC has now imposed penalties of just under $1.3 billion on entities for manipulative conduct with respect to LIBOR submissions and other benchmark interest rates. See In the Matter of The Royal Bank of Scotland plc and RBS Securities Japan Limited, Order Instituting Proceedings Pursuant To Sections 6(c) And 6(d) Of The Commodity Exchange Act, Making Findings And Imposing Remedial Sanctions (February 6, 2013) ($325 Million penalty) (see CFTC Press Release 6510-13); In the Matter of UBS AG and UBS Securities Japan Co., Ltd., Order Instituting Proceedings Pursuant To Sections 6(c) And 6(d) Of The Commodity Exchange Act, Making Findings And Imposing Remedial Sanctions (December 19, 2012) ($700 Million penalty) (see CFTC Press Release 6472-12); and In the Matter of Barclays PLC, Barclays Bank PLC, and Barclays Capital Inc., Order Instituting Proceedings Pursuant To Sections 6(c) And 6(d) Of The Commodity Exchange Act, As Amended, Making Findings And Imposing Remedial Sanctions (June 27, 2012) ($200 million penalty) (see CFTC Press Release 6289-13). In the actions against the panel banks, the CFTC Orders also require the banks to comply with undertakings specifying the factors upon which benchmark interest rate submissions should be made, and requiring implementation of internal controls and policies needed to ensure the integrity and reliability of such communications.

CFTC Division of Enforcement staff members responsible for this case are Aimée Latimer-Zayets, Anne M. Termine, Maura M. Viehmeyer, James A. Garcia, Boaz Green, Kassra Goudarzi, Rishi K. Gupta, Jonathan K. Huth, Timothy M. Kirby, Terry Mayo, Elizabeth Padgett, Michael Solinsky, Philip P. Tumminio, Jason T. Wright, Gretchen L. Lowe, and Vincent A. McGonagle.

FROM:  COMMODITY FUTURES TRADING COMMISSION
Statement of Chairman Gary Gensler on Settlement Order against ICAP
September 25, 2013

Washington, DC — Commodity Futures Trading Commission (CFTC) Chairman Gary Gensler today made the following statement on the CFTC’s enforcement action that requires ICAP Europe Limited to pay a $65 million penalty for unlawful conduct related to LIBOR for yen:

“Today’s Order against ICAP once again shows how LIBOR, a critical benchmark interest rate not anchored in sufficient transactions, has been readily rigged. Unfortunately, this is yet another reminder of why we have to coordinate internationally to transition to an alternative to LIBOR to best restore the integrity to markets.

“Today’s Order also highlights the importance of Congress’ reforms through the Dodd-Frank Act to bring oversight to swaps trading platforms.  Required registration of swap execution facilities becomes a reality next week, finally closing exemptions that had allowed for unregistered, multilateral swaps trading platforms."

FROM:  COMMODITY FUTURES TRADING COMMISSION
“Champagne and Ferraris”

Statement of CFTC Commissioner Bart Chilton on the ICAP Order

September 25, 2013

Here we are, sadly, with traders again behaving badly. Another bust, another one bites the dust.

In this instance, ICAP brokers attempted to falsely report Libor rates in order to advantage another trader. This was insolent conduct impacting a benchmark rate that influences almost anything consumers buy on credit.  These benchmarks are just too important to become a playground for some big-talking bad guys.

Email exchanges exhibit total disregard for proper protocols. In one case, champagne was promised for a favorable fixing.  Some sought increased kickbacks or free meals—a curry meal for currying favors.  One even mentioned (perhaps in jest) a Ferrari as payment for the favors.  “They are making fortunes with these high fixings,” said one communication.

The attempts to manipulate Libor have been a black eye for our global financial system.  It’s good that we have made progress at cleaning up this monstrous mess.  I congratulate our Division of Enforcement for cracking yet another of these cases and appreciate the cooperative working relationship we have had with the Financial Conduct Authority in the U.K.

Let's hope other would-be crooks learn a lesson here and stay clear of future violations.

Note: Ponzimonium: How Scam Artists are Ripping Off America, is now available in a FREE EBOOK edition.

MAN INDICTED IN $20 MILLION PROMISSORY NOTE FRAUD CASE

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION 
Joseph Paul Zada Indicted for Fraud

The Securities and Exchange Commission announced today that on September 4, 2013, a Grand Jury sitting in the United States District Court for the Southern District of Florida returned an Indictment charging Joseph Paul Zada with 21 counts of mail fraud, two counts of wire fraud, two counts of money laundering, and two counts of interstate transportation of stolen property. The Indictment also seeks forfeiture of properties obtained as a result of the alleged criminal violations.

The Indictment alleges that from at least January 1998 through August 2009, Zada caused over twenty investors to invest over $20 million based on materially false statements and omissions. According to the Indictment, Zada attracted investors by projecting an image of great wealth, portraying himself as a successful businessman and investor with connections to Saudi Arabian oil ventures. He also hosted extravagant parties, drove expensive luxury vehicles, and maintained expensive homes in Wellington, Florida and Grosse Pointe, Michigan. The investors sent money to Zada with the understanding that he would use the funds to invest in various oil ventures on their behalf. The investors usually received promissory notes reflecting the principal amount of their investment. Zada deposited investors' funds into bank accounts he controlled. Instead of investing the funds in oil ventures, Zada used the money to support his lavish lifestyle and to make purported returns on investments to prior investors.

The Indictment's allegations are based on the same conduct underlying the Commission's November 10, 2010 Complaint against Zada in the United States District Court for the Eastern District of Michigan. The Commission charged Zada with violations of Sections 5(a), 5(c), and 17(a) of the Securities Act of 1933, and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. On July 31, 2013, the Court granted the Commission's motion for summary judgment against Zada, finding that Zada had violated the provisions alleged by the Commission in its Complaint. The Court set a hearing for October 9, 2013 on the Commission's claims for disgorgement and civil penalties against Zada.

SEC VOTES ON RULES TO ESTABLISH REGISTRATION REGIME FOR MUNICIPAL ADVISORS

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION

The Securities and Exchange Commission today voted unanimously to adopt rules establishing a permanent registration regime for municipal advisors as required by the Dodd-Frank Act.

State and local governments that issue municipal bonds frequently rely on advisors to help them decide how and when to issue the securities and how to invest proceeds from the sales.  These advisors receive fees for the services they provide.  Prior to passage of the Dodd-Frank Act, municipal advisors were not required to register with the SEC like other market intermediaries.  This left many municipalities relying on advice from unregulated advisors, and they were often unaware of any conflicts of interest a municipal advisor may have had.

After the Dodd-Frank Act became law, the SEC established a temporary registration regime.  More than 1,100 municipal advisors have since registered with the SEC.

The new rule approved by the SEC requires a municipal advisor to permanently register with the SEC if it provides advice on the issuance of municipal securities or about certain “investment strategies” or municipal derivatives.

“In the wake of the financial crisis, many municipalities suffered significant losses from complex derivatives and other financial transactions, and their investors were left largely unprotected from these risks,” said SEC Chair Mary Jo White.  “These rules set forth clear, workable requirements and guidance for municipal advisors and other market participants, which will provide needed protections for investors in the municipal securities markets.”

The new rules become effective 60 days after they are published in the Federal Register.

SEC CHARGES MONEY MANAGER FOR ALLEGEDLY USING INVESTOR FUNDS FOR PERSONAL USE

FROM:  SECURITIES AND EXCHANGE COMMISSION
SEC Charges Purported Money Manager in New York Who Schemed Investors and Lied to SEC Examiners

The Securities and Exchange Commission today charged the owner of a New York-based investment advisory firm with defrauding investors while grossly exaggerating the amount of assets under his management.

The SEC alleges that Fredrick D. Scott registered his firm ACI Capital Group as an investment adviser and then embarked on a series of fraudulent schemes targeting individual investors and small businesses.  Scott repeatedly touted ACI’s registration under the securities laws and falsely claimed the firm’s assets under management to be as high as $3.7 billion to bolster his credibility when offering too-good-to-be-true investment opportunities.  As Scott solicited funds from investors after promising them very high rates of return, he simply stole their money almost as soon as they deposited it with ACI.  Scott paid no returns to investors and illegally used their money to fund such personal expenses as his children’s private school tuition, air travel and hotels, department store purchases, and several thousand dollars in dental bills.

In a parallel action, the U.S. Attorney’s Office for the Eastern District of New York today announced Scott has pleaded guilty to criminal charges.  Among the charges to which Scott has pleaded guilty is making false statements to SEC examiners when they questioned whether Scott and ACI had accepted loans from investors.  SEC examiners notified the agency’s Enforcement Division, which began investigating and referred the matter to criminal authorities.

According to the SEC’s complaint filed in federal court in Brooklyn, one variation of Scott’s fraud was a so-called advance fee scheme – Scott promised investors that ACI would provide multi-million dollar loans to people seeking bank financing.  But investors were told that they first needed to advance ACI a percentage of the loan amount, and once they did so they would receive the remaining balance of the amount that Scott promised to pay.  Scott had no intention of ever returning the money, nor did he repay it.

The SEC alleges that in another iteration of his fraud, Scott offered investors the opportunity to make a bridge loan to a third-party entity.  The investor was told to fund one portion of the loan, and ACI would supposedly fund the remaining balance.  In exchange, the investor would supposedly receive a substantial return on his initial investment.  In this scheme as with each of his others, investors never received returns and Scott stole the money.

The SEC’s complaint charges Scott with violating Section 17(a) of the Securities Act, Section 10(b) of the Securities Exchange Act and Rule 10b-5, Section 207 of the Investment Advisers Act for filing a false Form ADV, and aiding and abetting ACI’s improper registration in violation of Section 203A of the Advisers Act.

The SEC’s investigation was conducted in the New York office by Sharon Binger, Adam Grace, Justin Alfano, Elzbieta Wraga, and Jordan Baker.  The investigation stemmed from a referral by the SEC’s examination staff including Raymond Slezak, Michael O’Donnell, Kathleen Raimondi, and Ken Fong.  The SEC’s litigation will be led by Alexander Vasilescu.  The SEC appreciates the assistance of the U.S. Attorney’s Office for the Eastern District of New York and the Federal Bureau of Investigation.

CFTC COMMISSIONER CHILTON'S ASSESSMENT OF LOOMING GOVERNMENT SHUTDOWN

FROM:  COMMODITY FUTURES TRADING COMMISSION 
Boom, Boom, Out Go the Lights

Statement of CFTC Commissioner Bart Chilton

September 20, 2013

On September 30th, at the stroke of midnight, our country will face a government shutdown unless a continuing resolution to fund it is adopted.  That would be grave news for consumers.

Under a shutdown scenario, government regulators will be handcuffed in our ability to go after crooks who are trying to evade our oversight and protection of markets.  You can bet the “do-badders” are licking their chops.

The dark markets that Dodd-Frank brought into the light of day will go dark again.  The lights will go out.  Given the huge growth in the derivatives industry and our new oversight of swaps, CFTC’s market oversight functions are more important than ever.  Taking our cops off the beat for even a few days could have disastrous impacts on these markets that consumers depend upon.

In the longer term, I remain concerned about the stagnant budgetary circumstances and am convinced that a targeted transaction fee on trading, like the one the President has proposed to Congress, is needed to fund the agency and keep the markets safe.  But for now, let’s avoid a “Boom, Boom, Out Go the Lights” debacle, and hope a deal can be reached to keep the lights on.

SEC ANNOUNCES ENFORCEMENT ACTIONS AGAINST 23 FIRMS FOR SHORT SELLING VIOLATIONS

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION 

The Securities and Exchange Commission today announced enforcement actions against 23 firms for short selling violations as the agency increases its focus on preventing firms from improperly participating in public stock offerings after selling short those same stocks.  Such violations typically result in illicit profits for the firms.

The enforcement actions are being settled by 22 of the 23 firms charged, resulting in more than $14.4 million in monetary sanctions.

The SEC’s Rule 105 of Regulation M prohibits the short sale of an equity security during a restricted period – generally five business days before a public offering – and the purchase of that same security through the offering.  The rule applies regardless of the trader’s intent, and promotes offering prices that are set by natural forces of supply and demand rather than manipulative activity.  The rule therefore helps prevent short selling that can reduce offering proceeds received by companies by artificially depressing the market price shortly before the company prices its public offering.

The firms charged in these cases allegedly bought offered shares from an underwriter, broker, or dealer participating in a follow-on public offering after having sold short the same security during the restricted period.

“The benchmark of an effective enforcement program is zero tolerance for any securities law violations, including violations that do not require manipulative intent,” said Andrew J. Ceresney, Co-Director of the SEC’s Division of Enforcement.  “Through this new program of streamlined investigations and resolutions of Rule 105 violations, we are sending the clear message that firms must pay the price for violations while also conserving agency resources.”

The SEC’s National Examination Program simultaneously has issued a risk alert to highlight risks to firms from non-compliance with Rule 105.  The risk alert highlights observations by SEC examiners focusing on Rule 105 compliance issues as well as corrective actions that some firms proactively have taken to remedy Rule 105 concerns.

“This coordination between the enforcement and examination programs reaffirms that market participants must be in compliance with Rule 105 to preserve and protect the independent pricing mechanisms of the securities markets,” said Andrew Bowden, Director of the SEC’s National Exam Program.

In a litigated administrative proceeding against G-2 Trading LLC, the SEC’s Division of Enforcement is alleging that the firm violated Rule 105 in connection with transactions in the securities of three companies, resulting in profits of more than $13,000.  The Enforcement Division is seeking full disgorgement of the trading profits, prejudgment interest, penalties, and other relief as appropriate and in the public interest.

The SEC charged the following firms in this series of settled enforcement actions:

Blackthorn Investment Group – Agreed to pay disgorgement of $244,378.24, prejudgment interest of $15,829.74, and a penalty of $260,000.00.
Claritas Investments Ltd. – Agreed to pay disgorgement of $73,883.00, prejudgment interest of $5,936.67, and a penalty of $65,000.00.
Credentia Group – Agreed to pay disgorgement of $4,091.00, prejudgment interest of $113.38, and a penalty of $65,000.00.
D.E. Shaw & Co. – Agreed to pay disgorgement of $447,794.00, prejudgment interest of $18,192.37, and a penalty of $201,506.00.
Deerfield Management Company – Agreed to pay disgorgement of $1,273,707.00, prejudgment interest of $19,035.00, and a penalty of $609,482.00.
Hudson Bay Capital Management – Agreed to pay disgorgement of $665,674.96, prejudgment interest of $11,661.31, and a penalty of $272,118.00.
JGP Global Gestão de Recursos – Agreed to pay disgorgement of $2,537,114.00, prejudgment interest of $129,310.00, and a penalty of $514,000.00.
M.S. Junior, Swiss Capital Holdings, and Michael A. Stango – Agreed to collectively pay disgorgement of $247,039.00, prejudgment interest of $15,565.77, and a penalty of $165,332.00.
Manikay Partners – Agreed to pay disgorgement of $1,657,000.00, prejudgment interest of $214,841.31, and a penalty of $679,950.00.
Meru Capital Group – Agreed to pay disgorgement of $262,616.00, prejudgment interest of $4,600.51, and a penalty of $131,296.98.00.
Merus Capital Partners – Agreed to pay disgorgement of $8,402.00, prejudgment interest of $63.65, and a penalty of $65,000.00.
Ontario Teachers’ Pension Plan Board – Agreed to pay disgorgement of $144,898.00, prejudgment interest of $11,642.90, and a penalty of $68,295.
Pan Capital AB – Agreed to pay disgorgement of $424,593.00, prejudgment interest of $17,249.80, and a penalty of $220,655.00.
PEAK6 Capital Management – Agreed to pay disgorgement of $58,321.00, prejudgment interest of $8,896.89, and a penalty of $65,000.00.
Philadelphia Financial Management of San Francisco – Agreed to pay disgorgement of $137,524.38, prejudgment interest of $16,919.26, and a penalty of $65,000.00.
Polo Capital International Gestão de Recursos a/k/a Polo Capital Management – Agreed to pay disgorgement of $191,833.00, prejudgment interest of $14,887.51, and a penalty of $76,000.00.
Soundpost Partners – Agreed to pay disgorgement of $45,135.00, prejudgment interest of $3,180.85, and a penalty of $65,000.00.
Southpoint Capital Advisors – Agreed to pay disgorgement of $346,568.00, prejudgment interest of $17,695.76, and a penalty of $170,494.00.
Talkot Capital – Agreed to pay disgorgement of $17,640.00, prejudgment interest of $1,897.68, and a penalty of $65,000.00.
Vollero Beach Capital Partners – Agreed to pay disgorgement of $594,292, prejudgment interest of $55.171, and a penalty of $214,964..
War Chest Capital Partners – Agreed to pay disgorgement of $187,036.17, prejudgment interest of $10,533.18, and a penalty of $130,000.00.
Western Standard – Agreed to pay disgorgement of $44,980.30, prejudgment interest of $1,827.40, and a penalty of $65,000.00.
The SEC’s investigations were conducted by Conway T. Dodge, Anita B. Bandy, Lauren B. Poper, Christina M. Adams, Allen A. Flood, Kevin J. Gershfeld, Wendy Kong, Mary S. Brady, Ian S. Karpel, Kimberly L. Frederick, and J. Lee Robinson.  The SEC’s litigation will be led by James A. Kidney.  The SEC appreciates the ongoing assistance of the Financial Industry Regulatory Authority.

CFTC COMMISSIONER O'MALIA'S OPENING STATEMENT AT CFTC TECHNOLOGY ADVISORY COMMITTEE

FROM:  COMMODITY FUTURES TRADING COMMISSION 
Opening Statement of Commissioner Scott D. O’Malia, Chairman of the CFTC Technology Advisory Committee, Washington, DC

September 12, 2013

I would like to welcome our TAC members, members of the Subcommittee on Automated and High Frequency Trading, and other guests. I thank you all for joining us here. Our discussion today will include three panels: (1) SDR data harmonization, (2) the Commission’s recently published Concept Release on automated trading, and (3) SEF registration and compliance, and MAT submissions.

When I reinstated the Technology Advisory Committee (TAC) not long after I joined the Commission, I did so with the goal of providing a means by which the industry and the Commission could work together to discuss and resolve the challenges imposed on the marketplace by the Dodd-Frank Act. For the past two years, I have held regular meetings of the TAC to foster open discussion and find innovative solutions to technological issues with respect to pre-trade functionality,1 data standards,2 automated and high frequency trading,3 and customer protection.4

Panel I: Swap Data Reporting

This year, we have been confronted by serious problems related to the CFTC’s acceptance, aggregation, and analysis of data submitted to the Swap Data Repositories (SDRs). This is not a surprise—one of the first topics addressed by the TAC was data standardization—but the challenges have really hit home now, with SDR reporting fully underway.

In January 2012, the Commission finalized Parts 435 and 456 of Commission regulations for both real-time and regulatory reporting of swap transactions. However, because of inconsistencies and errors in these rules and the data, the Commission has been unable to effectively utilize the reported data.

Accordingly, at the April 30 meeting of the TAC, I asked Commission staff and the three temporarily-registered SDRs to work on harmonizing the data reporting process, field-by-field, in order to ensure that the data submitted to the Commission by SDRs is consistent and usable, regardless of how this data was submitted to the SDRs. This will ensure that we can aggregate data across the SDRs and perform the necessary analysis. Alignment may also identify new reporting requirements that should be considered and implemented in order to improve the data reporting process.

Further, I have asked that this work be carried out through the TAC so that the process can be open to the public and benefit from thoughtful consideration by the industry. In fact, I will use the TAC to demonstrate the harmonization progress that has been achieved so far, and to accept comments on the proposed modifications. Using this feedback, we can hand over the work done by the TAC to the Commission for possible adoption in the future. Today, we will post the data harmonization chart on the TAC website for public review and invite comment. I have also included links to the SDRs’ real-time ticker data as well.

I am pleased that our first panel today will begin with John Rogers, Director of the Office of Data and Technology (ODT), to report on the progress made by the harmonization working group. Next, we will hear from Richard Berner, the Director of Treasury’s Office of Financial Research (OFR), to discuss federal agency coordination. Then, we will hear from Nicolas Gauthier, Policy Officer, Internal Markets and Services with the European Commission (EC), who will provide the European perspective on cross-border data issues. Mr. Gauthier will also provide an international perspective on trading platforms and execution this afternoon as part of our SEF panel. We are honored to have Mr. Gauthier, who has traveled a considerable distance to participate in this meeting, with us today.

Panel II: Concept Release on Automated Trading

Our discussion will next address the Commission’s recently published Concept Release on Risk Controls and System Safeguards for Automated Trading Environments.7 We will begin the second panel with an overview of the Concept Release by Sebastian Pujol-Schott, Associate Director of the Division of Market Oversight (DMO), and then begin general discussion by the TAC members. Given that the Concept Release was published earlier this week and asks over a hundred questions about very specific trading controls and their deployment in the market, I realize that TAC and subcommittee members may not have had the chance to engage in a full analysis. Nevertheless, I encourage you to participate in this discussion by sharing your immediate reactions to the Concept Release generally, addressing any of the questions it poses, and asking questions of the staff—in short, I welcome any input to help make this a productive discussion.

As I noted earlier, the TAC has spent its time and resources to help strengthen the Commission’s understanding of automated markets. I would like to thank all the TAC members, as well as the members of the Subcommittee on Data Standardization and the Subcommittee on Automated and High Frequency Trading, for their hard work on issues related to automated trading systems and pre-trade functionality. This body of work includes a working definition of “high frequency trading,” as well as a recent TAC reference document that compiled existing standards and recommendations in the market today.8

Today, I would like to build on the TAC’s past work and now focus on better understanding the following issues presented by automated trading systems and high frequency trading:

First, I’d like to learn more about the technology that is deployed today, as well as its effectiveness.

Second, I would like to understand whether there is a need for regulatory action with regard to any of the measures currently in the market. In other words, should the Commission federalize any current industry practices/standards?

Finally, it would be beneficial to receive feedback on the possibility of a registration requirement for firms operating automated trading systems that are not otherwise registered with the Commission. The Concept Release cites the definition of “floor broker” as the potential basis for such a requirement. I am interested to get public input on whether this, or any other provision in the Commission’s statute or regulations, can serve as a legal basis for registration.

Panel III: SEFs / MAT Submissions

Last but not least, I have added a special panel to discuss the status of SEF registration applications, as well as to raise various issues that both SEFs and SEF participants are facing because of the fast-approaching SEF compliance date.

We are only twenty days away from October 2. This means that we are only twenty days away from the SEFs’ ribbon-cutting ceremony, and only twenty days away from the official shutdown of Exempt Commercial Markets (ECMs) and Exempt Boards of Trade (EBOTs). As of today, the staff has temporarily registered three SEFs and has to review fifteen more applications before October 2.

In the midst of this transitional period, we have heard many concerns from different market participants (including SEFs, dealers, clearing members, and other SEF participants) regarding various interpretations of the SEF rules and a number of operational challenges. I would like to have an open discussion of a number of issues surrounding on-boarding, clearing certainty, uniformity of SEF rulebooks, and the status of Made Available to Trade (MAT) determinations. To address these issues, David Van Wagner, the Chief Counsel of DMO, is here to answer your questions.

Thank you all for attending today’s meeting of the TAC. I look forward to addressing these important issues as the Commission continues to implement Dodd-Frank and consider its practical and technological challenges.

1 TAC Pre-Trade Functionality Subcommittee of the CFTC Technology Advisory Committee Report, “Recommended Practices for Trading Firms, Clearing Firms and Exchanges Involved in Direct Market Access,” March 1, 2011, available at

http://www.cftc.gov/ucm/groups/public/@swaps/documents/dfsubmission/tacpresentation030111_ptfs1.pdf;

“Compilation of Existing Testing and Supervision Standards, Recommendations and Regulations,” Technology Advisory Committee Meeting, Oct 30, 2012, available at http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/tac103012_reference.pdf.

2 See TAC Meetings Transcript for December 13, 2011 and March 29, 2012, available at, http://www.cftc.gov/About/CFTCCommittees/TechnologyAdvisory/tac_meetings.

3 See TAC Meetings Transcript for March 1, 2011, June 20, 2012, and October 30, 2012, available at http://www.cftc.gov/About/CFTCCommittees/TechnologyAdvisory/tac_meetings.

4 See TAC Meeting Transcripts for July 26, 2012, October 30, 2012, and April 30, 2012, available at http://www.cftc.gov/About/CFTCCommittees/TechnologyAdvisory/tac_meetings.

5 See 17 C.F.R. § 43, available at http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2011-33173a.pdf.

6 See 17 C.F.R. § 45, available at http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2011-33199a.pdf.

7 This document is available at http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/federalregister090913.pdf.

8 This document is available at http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/tac103012_reference.pdf.

Last Updated: September 20, 2013

COURT ORDERS MAN AND COMPANY TO PAY OVER $2.4 MILLION IN FOREIGN CURRENCY SCHEME

FROM:   COMMODITY FUTURES TRADING COMMISSION 
Federal Court Orders Alex Ekdeshman and Paramount Management, LLC, to Pay over $2.4 million in Restitution and a Fine for Fraudulent Foreign Currency Scheme
Court Order Stems from a CFTC Complaint that Charged Defendants with Solicitation Fraud and Misappropriation of Customer Funds

Washington, DC – The U.S. Commodity Futures Trading Commission (CFTC) obtained a federal court consent Order against Defendants Alex Ekdeshman of Holmdel, New Jersey, and Paramount Management, LLC (Paramount), requiring them to pay $1,146,000 in restitution to their defrauded customers and a $1,337,000 civil monetary penalty. The Consent Order of Permanent Injunction also imposes permanent trading and registration bans against the Defendants and prohibits them from violating the anti-fraud provisions of the Commodity Exchange Act, as charged.

The Order was entered on September 9, 2013, by U.S. District Judge Colleen McMahon of the Southern District of New York and stems from a CFTC Complaint filed against the Defendants on June 26, 2013. The CFTC’s Complaint charged Ekdeshman, individually and as the agent of Paramount, with solicitation fraud and misappropriating “the vast majority” of customer funds for business expenses. Specifically, the Complaint charged the Defendants with operating a fraudulent scheme that solicited more than $1.3 million from approximately 110 retail customers to engage in leveraged or margined foreign currency (forex) transactions with unregistered off-shore counterparties. The Defendants allegedly advised customers that forex trading accounts would be opened in the customer’s name and would be traded by the Defendants on behalf of the customer.

Furthermore, the Defendants, through a telemarketing sales force and a “Performance Record” linked to their website, touted Paramount’s successful trading record as having yielded an average monthly return of 4.6% over a 20-month period, based on the performance of Paramount’s proprietary trading software system, according to the Complaint.

However, the court’s Order finds that, contrary to the claims made during the solicitations, the Defendants did not manage or trade any customer account, and thus Paramount’s customers neither made actual purchases of any forex nor received delivery of forex. The Order also finds that the Defendants misappropriated all customer funds for Ekdeshman’s personal benefit and failed to disclose to actual or prospective customers that they were misappropriating customer funds. To conceal their fraud, the Order finds that, during all phases of the scheme, the Defendants issued false account statements to their customers, as no individual customer accounts were ever created and no profits were ever generated.

The CFTC appreciates the assistance of the United Kingdom Financial Conduct Authority, the Financial Services Commission Mauritius, and the Financial Services Board of the Republic of South Africa.

Further, the CFTC appreciates the assistance of the Wisconsin Department of Financial Institutions, the National Futures Association, and the Federal Trade Commission.

CFTC Division of Enforcement staff members responsible for this matter are Thomas Kelly, Michael Amakor, Michael Geiser, Melanie Devoe, George Malas, Timothy J. Mulreany, Paul Hayeck, and Joan Manley.

CFTC ORDERS BROKER EMPLOYEE TO PAY PENALTY FOR MAKING FALSE STATEMENTS

FROM:  COMMODITY FUTURES TRADING COMMISSION 
CFTC Orders Futures Broker Employee Susan Butterfield to Pay $50,000 Penalty in Settlement of Charges of Making False Statements to the CFTC During Her Investigative Testimony

Washington, DC – The U.S. Commodity Futures Trading Commission (CFTC) today announced that it entered an Order requiring Susan Butterfield of New Lenox, Illinois, to pay a $50,000 civil monetary penalty for making false statements of material fact in testimony to CFTC staff during a CFTC Division of Enforcement investigation. The Order enforces the false statements provision of the Commodity Exchange Act (CEA), which was added by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act).

According to the CFTC’s Order, Butterfield, an employee of a company registered with the Commission as an introducing broker (the IB), handled various clerical and administrative responsibilities concerning trading on the floor of the Chicago Board of Trade (CBOT). Her responsibilities included accepting and recording customer orders. When done properly, this involved time-stamping paper order tickets contemporaneously with the receipt of a customer commodity futures or options order to accurately record the time of day when the IB received the order.

On January 31, 2013, Butterfield gave sworn testimony in an investigation being conducted by the CFTC’s Division of Enforcement. The CFTC Order finds that during that testimony, Butterfield knowingly made false and misleading statements regarding whether she had improperly pre-stamped order tickets, i.e., whether she stamped order tickets in blank, prior to the time when a customer order was actually received. As the Order states, this testimony was significant in that use of pre-stamped order tickets may violate Commission Regulations and CBOT rules and also may facilitate unlawful trade allocation schemes in which brokers decide who will receive trades only after they are executed, potentially allowing them to profit at their customers’ expense.

The CFTC Order finds that prior to her CFTC testimony Butterfield told her supervisor, who was a principal at the IB, that “we pre-stamp orders and it’s something that is – that we should not be doing.” However, on January 31, 2013, when the Division of Enforcement staff questioned Butterfield on the IB’s pre-stamping practice, Butterfield falsely told the staff that she “never pre-stamped any [order] tickets.” Later during the course of her testimony the same day, Butterfield admitted to various instances of pre-stamping order tickets, but only after she was confronted by documents that plainly contradicted her initial false testimony. Ultimately, having been confronted with evidence that demonstrated her falsehoods, Butterfield admitted by the end of her testimony that it was in fact her daily practice to pre-stamp order tickets from multiple futures commission merchants throughout the trading session, in numbers amounting to dozens of order tickets every day.

David Meister, the CFTC’s Enforcement Director, stated: “When a witness walks into CFTC testimony he or she should plan to tell the truth to every question or face the consequences. We will use the new Dodd-Frank false statements provision against witnesses who provide false or misleading information to make sure it is well understood that lying is not an option.”

In addition to the $50,000 civil monetary penalty, the CFTC Order requires Butterfield to cease and desist from violating the relevant provision of the CEA, to never apply for or claim exemption from registration with the CFTC or engage in any activity requiring such registration or exemption, and to never act as a principal or officer of any entity registered or required to be registered with the CFTC.

The CFTC Division of Enforcement staff members responsible for this matter are Allison Passman, Theodore Z. Polley III, Joseph Patrick, Susan Gradman, Scott Williamson, Rosemary Hollinger, and Richard B. Wagner.

SEC.gov | Statement at the SEC Open Meeting

SEC.gov | Statement at the SEC Open Meeting

SEC CHARGES OWNER OF INVESTMENT ADVISORY WITH DEFRAUDING INVESTORS

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION 

The Securities and Exchange Commission today charged the owner of a New York-based investment advisory firm with defrauding investors while grossly exaggerating the amount of assets under his management.

The SEC alleges that Fredrick D. Scott of Brooklyn, N.Y., registered his firm ACI Capital Group as an investment adviser and then embarked on a series of fraudulent schemes targeting individual investors and small businesses.  Scott repeatedly touted ACI’s registration under the securities laws and falsely claimed the firm’s assets under management to be as high as $3.7 billion to bolster his credibility when offering too-good-to-be-true investment opportunities.  As Scott solicited funds from investors after promising them very high rates of return, he simply stole their money almost as soon as they deposited it with ACI.  Scott paid no returns to investors and illegally used their money to fund such personal expenses as his children’s private school tuition, air travel and hotels, department store purchases, and several thousand dollars in dental bills.

In a parallel action, the U.S. Attorney’s Office for the Eastern District of New York today announced Scott has pleaded guilty to criminal charges.  Among the charges to which Scott has pleaded guilty is making false statements to SEC examiners when they questioned whether Scott and ACI had accepted loans from investors.  SEC examiners notified the agency’s Enforcement Division, which began investigating and referred the matter to criminal authorities.

“Scott told brazen lies about the value of ACI’s assets under management and its ability to deliver huge returns on various investments,” said Andrew M. Calamari, Director of the SEC’s New York Regional Office.  “Our examination and enforcement staff aggressively pursue investment advisers who flout the registration provisions of the securities laws for their personal gain, especially those who attempt to cover up their misdeeds by flat-out lying to our examiners.”

According to the SEC’s complaint filed in federal court in Brooklyn, one variation of Scott’s fraud was a so-called advance fee scheme – Scott promised investors that ACI would provide multi-million dollar loans to people seeking bank financing.  But investors were told that they first needed to advance ACI a percentage of the loan amount, and once they did so they would receive the remaining balance of the amount that Scott promised to pay.  Scott had no intention of ever returning the money, nor did he repay it.

The SEC alleges that in another iteration of his fraud, Scott offered investors the opportunity to make a bridge loan to a third-party entity.  The investor was told to fund one portion of the loan, and ACI would supposedly fund the remaining balance.  In exchange, the investor would supposedly receive a substantial return on his initial investment.  In this scheme as with each of his others, investors never received returns and Scott stole the money.

The SEC’s complaint charges Scott with violating Section 17(a) of the Securities Act, Section 10(b) of the Securities Exchange Act and Rule 10b-5, Section 207 of the Investment Advisers Act for filing a false Form ADV, and aiding and abetting ACI’s improper registration in violation of Section 203A of the Advisers Act.

The SEC’s investigation was conducted in the New York office by Sharon Binger, Adam Grace, Justin Alfano, Elzbieta Wraga, and Jordan Baker.  The investigation stemmed from a referral by the SEC’s examination staff including Raymond Slezak, Michael O’Donnell, Kathleen Raimondi, and Ken Fong.  The SEC’s litigation will be led by Alexander Vasilescu.  The SEC appreciates the assistance of the U.S. Attorney’s Office for the Eastern District of New York and the Federal Bureau of Investigation.

REMARKS BY FDIC VICE CHAIRMAN HOENIG ON 5 YEAR ANNIVERSARY OF LEHMAN BROTHERS MELTDOWN

FROM:  FEDERAL DEPOSIT INSURANCE CORPORATION 
Lehman Brothers: Looking Five Years Back and Ten Years Ahead
Remarks by Thomas M. Hoenig, Vice Chairman, Federal Deposit Insurance Corporation
Presented to the National Association of Corporate Directors, Texas TriCities Chapter Conference, Houston, Texas 
September 2013 
Introduction

A fundamental principle in economics is that incentives matter.  If the rules of the game provide advantages to some over others, protect players against the fallout of taking on excessive risk, or enable irresponsible behavior, we can be confident that the choices people make will be imprudent and the results of the misaligned incentives will be bad.

In the US financial system these conditions were in force during the decade leading to the Great Recession. It was a decade when monetary policy was highly accommodative; when government protections and subsidies were extended to ever more financial activities; when market discipline became a buzz word rather than a tool; and when the competitive advantage bestowed on some sectors of the industry led to a less competitive market.

More concerning is that five years after the crisis, despite new laws and regulations, we are replicating many of the conditions that contributed to the crisis, but we somehow are expecting things to end differently.   How so?

This morning, I will discuss the parallels between this earlier period and now, and I will make a case for a bolder set of actions to address weaknesses in a system that continues to impede our financial markets and economy.

Setting the Stage: Low Interest Rates

Extended periods of exceptionally low interest rates undermine a sound economy.  Their short-term effects on the economy can be favorable and dramatic, which creates a significant temptation for policymakers to keep rates low for a considerable period.   However, history suggests that extended periods of abnormally low rates often lead to negative long-run effects as they weaken credit standards, encourage the heavy use of credit, and too often adversely affect financial and economic stability.

For example, starting with the Mexican financial crisis of 1994 through the Asian and Russian crises of the late ’90s, aggressive expansionary US monetary policy was used with apparent success.  In each instance, the immediate crisis was staunched, markets continued operating, and the economy bounced back. Such success led to the expectation that monetary policy could clean up the effects of any financial excess or imbalance that the US economy might develop.   Low interest rates became the expected remedy that would stimulate the economy and avoid recession, or that would prevent the proliferation of a crisis.

Having been successful during the ’90s, the Federal Open Market Committee (FOMC), "doubled down" its use of low interest rates during the subsequent decade as it encountered financial and economic weaknesses. Following the collapse of the tech bubble, the real federal funds rate was negative for most of the period 2002 through 2005. It is noteworthy that in June 2003, the nominal federal funds rate was lowered from 1 1/4 percent to 1 percent and remained there for nearly a year, despite the fact that the economy grew at a rate of nearly 7 percent in the quarter following this rate reduction.

Because there were no signs of accelerating inflation, the FOMC felt confident that there was no need to quickly reverse policy, so it remained either highly or relatively accommodative well into the recovery. The first increase in the federal funds rate occurred in June 2004, only after evidence was overwhelming that economic activity had begun to accelerate. Not until March 2006 did the federal funds rate reach its long-term average level.

Within an environment of a highly accommodative monetary policy and sustained low interest rates, credit growth accelerated and serious financial imbalances developed. During the period 2002 to the end of 2007, total debt outstanding for households and financial and non-financial firms increased from $22 trillion to $37 trillion, or almost 70 percent. In hindsight, of course, it seems obvious that problems would result.

This history begs the question, therefore, of how current monetary policy might affect economic and financial conditions in 2013 and beyond. The FOMC again is fully engaged in conducting a highly accommodative monetary policy. The target federal funds rate is currently zero to 25 basis points. Through the Federal Reserve’s Quantitative Easing policy, its balance sheet and bank reserves have ballooned to nearly four times the size they were in January 2008. As a result, the real federal funds rate has been negative for most of the period from 2008 to the present.

As with the earlier period, inflation in the US remains relatively subdued, facilitating continued low rates. However, the US also is experiencing significant price increases in various assets, including, for example, land, stocks, and bonds. Banks and the entire financial sector are exposed, directly and indirectly, to significant negative price shocks in nearly all interest rate-sensitive sectors. Also, as capital desperately seeks out yield, there have been significant US dollar capital flows across the globe, causing what appears to be increased financial vulnerability, uncertainty, and instability.

Thus, the actions the FOMC has taken since the crisis ended are more aggressive and will be in place far longer than those taken in the early part of the last decade.

Those who support current money policy insist that circumstances are different this time - a phrase itself that should cause alarm. They suggest that policymakers have better tools to deal with imbalances in the form of renewed market discipline and macro-prudential supervision. However, as I describe below, financial conditions within the system are not as different than many presume. Market discipline has not been strengthened, and macro-prudential supervision may be a new name but it is hardly a tool that was unavailable in the earlier period.

Extending the Safety Net: Adding Risk to the System

During the early part of the last decade, at the time the US was engaging in a systematic expansion of monetary policy, it had just extended the public safety net to an ever wider set of financial activities and firms. In 1999, the Glass-Steagall Act was repealed, which confined the safety net – defined as access to the Federal Reserve liquidity facility and FDIC insurance -- to commercial banks. In its place, the Gramm-Leach-Bliley Act was passed to allow the melding of commercial banking, investment banking, and broker-dealer activities. These changes were intended to enhance the market's role in the economy, to increase competition, and to create a more diversified, stable system.

In practice, however, Gramm-Leach-Bliley undermined that very goal. It allowed firms with access to the public safety net to control a much wider array of financial products and activities, and it provided them a sizable advantage over financial firms outside the safety net. It enabled firms inside the net to fund themselves at lower costs and expand their use of debt -- that is, to lever-up. Under such conditions, firms outside the net, to survive, found it necessary to join this favored group through mergers or other actions. The result is a more highly concentrated industry that is more dependent on government support and where, in the end, the failure of any one firm threatens the broader economy.

Gramm-Leach-Bliley fundamentally changed the financial industry’s business model. Previously, commercial banking involved principally the payments system that transfers money around the country and world, and the intermediation process that transforms short-term deposits into longer-term loans. That model cultivated a culture of win-win, where the success of the borrower meant success to the lender in terms of the repayment of the loan and growth of the credit relationship.

After Gramm-Leach-Bliley, as broker dealer and trading activities began to dominate the banking model, the culture became one of win-lose, with the parties placing bets on asset price movements or directional changes in activity. Thus, broadening the range of activities and risks that banking firms could bring within the safety net changed the risk/return trade-off and significantly changed the incentive structure in banking. While such non-traditional commercial banking activities are essential to the market's function, placing them within the safety net became lethal to the industry and to the economy.

A related effect of the government’s rich financial subsidy was a significant increase in industry leverage, especially among the largest firms. Between 2000 and 2008, the leverage among the 10 largest US firms reached unprecedented levels, as the ratio of tangible assets to tangible common equity capital increased from 22 to 1 to levels exceeding 47 to 1.1

Once the financial panic was set in motion and confidence was lost, firms were forced to rapidly deleverage their balance sheets, creating a chaotic market. The effects were channeled through a highly interconnected financial system to the real economy, causing significant declines in asset values, wealth, and jobs. Between 2008 and the end of 2009, well over 8 million jobs were lost within the US economy alone, and containing the crisis required enormous amounts of FDIC and taxpayer support.

Now, five years after the crisis, we should not ignore that many of the conditions that undermined the economy then still remain within our financial system. These conditions include: a few dominant financial firms – those that are too big to fail - controlling an ever greater portion of financial assets within the US; continued government protections and related subsidies; and the continued reliance on a business model with its heavy use of debt over equity and increased risk in the pursuit of higher, subsidized returns on equity.

Yes, the Dodd-Frank Act introduced hundreds of regulations designed to control the actions of financial firms. It gives financial supervisors increased oversight of firms and activities, and it requires the Federal Reserve and the FDIC to oversee the development of resolution programs for the largest firms. However, when you work through the details, the law and rules mostly reiterate powers long available to supervisors. It adds numerous rules and moves responsibilities among regulators, but it makes no fundamental change in the industry’s structure or incentives that drive firms’ actions.

Dodd-Frank adds new supervisory and resolution authorities intended to end bail outs of financial firms and related subsidies. However, this is an old promise and has yet to be successfully implemented. Consider that the US financial system is more concentrated today and the largest firms hold more market power than prior to the crisis. The 10 largest financial firms control nearly 70 percent of the industry's assets, up from 54 percent in 2000. The eight globally systemic US banking firms hold in assets the equivalent of 90 percent of GDP, when you place the fair value of derivatives onto their balance sheets. Moreover, given the breadth and complexity of activities of these firms, they remain highly interconnected and the failure of any one will likely cause a systemic crisis, demanding government intervention.

Dodd-Frank introduces new rules designed to check the expansion of the subsidy. The Volcker Rule, for example, is supposed to move bank trading activities away from the insured bank. However, the rule has yet to be implemented, and even if it is fully implemented, it allows broker-dealer activities to stay within the same corporate entity, which itself benefits from the government’s safety net.

Consistent with these observations, there is a long list of studies documenting the existence of a government subsidy unique to the largest firms that extends across their balance sheets. While the industry vigorously argues that no subsidy exists, the preponderance of evidence suggests otherwise.2 Thus, while new authorities designed to mitigate this subsidy have been introduced, they have yet to be used or successfully tested. It is worth noting, for example, that under the Bank Holding Company Act, regulatory authorities have long had the authority to force divestiture of non-bank affiliates if they threaten the viability of the related bank. To my knowledge, this authority has never been used.

Therefore, as before the crisis, too big to fail and its subsidy continue to affect firms’ behavior. They enable the largest firms to fund themselves at lower cost than other firms providing a competitive advantage that facilitates the biggest firms’ dominance within the industry and multiplying their impact to the broader economy.

Also, although the US has introduced a supplemental leverage ratio to the capital standards, these largest firms carry significantly more leverage following from the subsidy than the industry more broadly. Using International Financial Reporting Standards, the average leverage ratio of the eight globally systemic US banks is nearly 25 to 1.3 This leverage is comparable to what the largest US firms carried in the years leading up to the crisis in 2008 and, as events demonstrated, it reflects too little capital to absorb significant shocks that might occur within the financial sector.

These leverage ratios stand in contrast to those for the remainder of the US banking industry. For example, the average leverage ratio for each category of banks -- from community, to regional, to super-regional -- is less than 14 to 1. This lower ratio reflects the fact that creditors of these firms are more directly exposed to loss should failure occur and, therefore, they insist on a larger capital cushion.

Thus, in comparing today’s financial system to that of 2008, I worry that the industry is more concentrated, that the system remains vulnerable to shock, and that the economy remains vulnerable to crisis. Even within the confines of Dodd-Frank, the industry’s structure, incentives and balance-sheets are more similar to 2008 than different. And, as always, we can’t anticipate the source of the shock until it strikes.

Rethinking Status Quo Solutions

It has been noted that, “We cannot solve our problems with the same thinking we used when we created them.”4 The economy has struggled through this recovery in a post Dodd-Frank environment perhaps because the public realizes that while we have more rules, too little has changed. It is my hope that people remain cautious so that five years from now – ten years after the collapse of Lehman Brothers – we will not be in an all-too-familiar place, facing an all-too-familiar banking crisis.

We need to regain our economic footing by rethinking our solutions. As I have been suggesting since before joining the FDIC, the US requires a monetary policy that better balances short-term and long-term policy goals. We need to rationalize, not consolidate, the structure of the financial industry and narrow the federal safety net to its intended purpose of protecting only the payments and intermediation systems that commercial banks operate.5 At a minimum, simplifying the structure would enhance the FDIC’s ability to implement its new authorities to resolve institutions should they fail. In addition, the US must lead the world in strengthening and simplifying the capital requirements for regulated financial firms, particularly for the largest, most systemically important firms.6 A strong capital base for individual firms and the industry is essential to a strong, market-based financial system.

A decentralized financial structure supported by a strong capital base and market accountability, too long ignored but fundamentally correct, would further change industry incentives and strengthen its performance. Finally, and importantly, these conditions would make the industry more responsive to the market, providing opportunity for success and failure -- both of which are essential elements of capitalism.



The views expressed are those of the author and not necessarily those of the FDIC

1 Tangible common equity capital is total equity capital less non-Treasury preferred stock, goodwill and other intangible assets.

2 http://www.fdic.gov/news/news/speeches/litreview.pdf
http://www.richmondfed.org/publications/research/special_reports/safety_net/pdf/safety_net_methodology_sources.pdf

3 The International Financial Reporting Standards (IFRS) approach to financial statement reporting is set by the International Accounting Standards Board.  A significant difference between U.S. GAAP and IFRS is IFRS only allows the netting of derivative instruments on the balance sheet when the ability and intent to settle on a net basis is unconditional. http://www.fdic.gov/about/learn/board/hoenig/capitalizationratios2q13.pdf

4 The quote is widely attributed Albert Einstein, though scholars have not verified its authenticity. http://www.albert-einstein-quotes.org.za/

5 “Restructuring the Banking System to Improve Safety and Soundness” white paper by Thomas M. Hoenig and Charles S. Morris - http://fdic.gov/about/learn/board/Restructuring-the-Banking-System-05-24-11.pdf
“A Turning Point: Defining the Financial Structure” speech by Thomas M. Hoenig to the Annual Hyman P. Minsky Conference at the Levy Economics Institute of Bard College. April 17, 2013 - http://fdic.gov/news/news/speeches/spapr1713.html

6 “Basel III Capital: A Well-Intended Illusion” speech by Thomas M. Hoenig to the International Association of Deposit Insurers 2013 Research Conference in Basel, Switzerland. April 9, 2013 - http://fdic.gov/news/news/speeches/spapr0913.html