CFTC OFFICIAL'S TESTIMONY BEFORE SENATE COMMITTEE REGARDING AUTOMATED TRADING ENVIRONMENTS

FROM:  U.S. COMMODITY FUTURES TRADING COMMISSION 

Testimony of Vincent McGonagle, Director of the Division of Market Oversight, Commodity Futures Trading Commission Before the U.S. Senate Committee on Agriculture, Nutrition and Forestry

May 13, 2014

Chairwoman Stabenow, Ranking Member Cochran and Members of the Committee, thank you for the opportunity to appear before you today. My name is Vincent McGonagle and I am the Director of the Division of Market Oversight at the Commodity Futures Trading Commission (CFTC or Commission). I am pleased to appear before the Committee to provide an overview of the CFTC’s Concept Release on Risk Controls and System Safeguards for Automated Trading Environments (Concept Release). The Concept Release reflects the Commission’s ongoing commitment to the safety and soundness of U.S. derivatives markets in times of technological change, including automated and high-frequency trading (HFT).

My written testimony today will describe the Concept Release and provide an overview of public comments received in response to the risk controls and market enhancements discussed therein. It will also describe the regulatory context in which automated and high-frequency trading currently operate, and numerous measures already taken by the Commission to safeguard trading in modern, technology-driven markets.

Background on Commodity Exchange Act and the CFTC’s Mission

The purpose of the Commodity Exchange Act (Act) is to serve the public interest by providing a means for managing and assuming price risks, discovering prices, or disseminating pricing information. Consistent with its mission statement and statutory charge, the CFTC is tasked with protecting market participants and the public from fraud, manipulation, abusive practices and systemic risk related to derivatives – both futures and swaps – and to foster transparent, open, competitive and financially sound markets. In carrying out its mission and statutory charge, and to promote market integrity, the CFTC polices derivatives markets for various abuses and works to ensure the protection of customer funds.

To fulfill these roles, the Commission oversees designated contract markets (DCMs), swap execution facilities (SEFs), derivatives clearing organizations, swap data repositories, swap dealers (SDs), futures commission merchants (FCMs) and other intermediaries. The Act generally requires that all futures transactions be conducted on or subject to the rules of a board of trade that the CFTC designates as a DCM. Sections 5 and 6 of the Act and Part 38 of the Commission’s regulations provide the legal framework for the Commission to designate DCMs, along with each DCM’s self-regulatory compliance requirements with respect to the trading of commodity futures contracts. With the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), DCMs were also permitted to list swap contracts. Dodd-Frank also adopted a new regulatory category for exchanges that provide exclusively for the trading of swaps (i.e., SEFs).

Exchanges’ Self-Regulatory Responsibilities and CFTC Oversight

DCMs and SEFs play an important role in the regulatory structure established for derivatives markets by the Act. As self-regulatory organizations (SROs) they are responsible for front-line oversight of all exchange-traded derivatives subject to the Commission’s jurisdiction. DCMs must comply with 23 core principles, including core principles requiring them to establish, monitor and enforce compliance with their rules and to have the capacity to detect, investigate and sanction violative conduct1 and to prevent manipulation and price distortion.2 SEFs are subject to 15 core principles and must comply with similar requirements to establish and enforce trading and participation rules that will deter abuses, and have the capacity to detect and investigate rule violations.3 SEFs are also required to monitor trading in swaps to prevent manipulation and price distortion.4 Commission regulations require DCMs and SEFs to prohibit abusive trading practices by exchange members and market participants, including abuses against customers. Prohibited practices include, but are not limited to, trading ahead of customer orders, accommodation trading, improper cross trading, front-running, wash-trading, pre-arranged trades unless otherwise permitted, fraudulent trading and money passes. DCMs and SEFs must prohibit any other manipulative or disruptive trading practice prohibited by the Act or Commission regulations, and any trading practice that the DCM or SEF believes to be abusive.5

To fulfill these responsibilities, DCMs and SEFs are required to and do maintain in-house compliance departments with appropriate human and technology resources, or to contract with third-party regulatory service providers recognized under the Act. DCMs and SEFs must also maintain complete audit trails. For example, DCMs have extensive electronic records of activity on their electronic trade matching platforms. A subset of such records—trade and related order data—is provided to the CFTC daily by DCMs for the Commission’s own surveillance activities.6

The Division of Market Oversight conducts rule enforcement reviews of DCMs’ self-regulatory programs and evaluates their compliance with the Act and Commission regulations. Such reviews aim to promote DCMs’ effective performance as SROs by examining core principles most closely-related to their self-regulatory programs. These include core principles governing DCMs’ trade practice surveillance, market surveillance, audit trail, and disciplinary programs. The Division will conduct similar reviews of SEFs in the future. In addition, the Division also conducts direct surveillance of its regulated markets, and continues to improve the regulatory data available for this purpose. For example, in November 2013 the Commission published final rules to improve its identification of participants in futures and swaps markets (OCR Final Rules).7 While enhancing the Commission’s already robust position-based reporting regime, the OCR Final Rules also create new volume-based reporting requirements that significantly expand the Commission’s view into its regulated markets, including with respect to high-frequency traders.

Expansion of CFTC Enforcement Authority under Dodd-Frank and New Regulations Relevant to Automated Markets

The Commission’s responsibilities under the Act include mandates to prevent and deter fraud, manipulation, and disruptive trading. Dodd-Frank broadened the Commission’s enforcement authority to include swaps markets. Under the new law and rules implementing it, the Commission’s anti-manipulation reach is extended to prohibit the reckless use of manipulative schemes. Specifically, Section 6(c)(3) of the Act now makes it unlawful for any person, directly or indirectly, to manipulate or attempt to manipulate the price of any swap, or of any commodity in interstate commerce, or for future delivery on or subject to the rules of any registered entity. In addition, new Section 4c(a) of the Act now explicitly prohibits disruptive trading practices, such as the violation of bids or offers, intentional or reckless disregard for the orderly execution of transactions during the closing period, or the placement of bids or offers with the intent to cancel such bids or offers before execution (commonly known as “spoofing”).8

A number of Commission rulemakings to implement Dodd-Frank have focused specifically on safeguards for automated trading. These new rules address both market participants, such as FCMs, SDs and others, and exchanges, including both DCMs and SEFs. In April 2012, the Commission adopted Regulations 1.73 and 23.609 requiring FCMs, SDs and major swap participants (“MSPs”) that are clearing members to establish risk-based limits based on “position size, order size, margin requirements, or similar factors” for all proprietary accounts and customer accounts.9 The rules also require FCMs, SDs and MSPs to “use automated means to screen orders for compliance with the [risk] limits” when such orders are subject to automated execution.10 The Commission also adopted rules in April 2012 requiring SDs and MSPs to ensure that their “use of trading programs is subject to policies and procedures governing the use, supervision, maintenance, testing, and inspection of the program.”11

In June 2012, the Commission adopted rules to implement the 23 core principles for DCMs.12 Regulation 38.255 requires DCMs to “establish and maintain risk control mechanisms to prevent and reduce the potential risk of price distortions and market disruptions, including, but not limited to, market restrictions that pause or halt trading in market conditions prescribed by the designated contract market.”13 Regulation 37.405 imposes similar requirements on SEFs.14 In addition, the Acceptable Practices for DCM Core Principle 4 (Prevention of Market Disruption) and Guidance to SEF Core Principle 4 (Monitoring of Trading and Trade Processing) identify pre-trade limits on order size, price collars or bands, message throttles and daily price limits as responsive measures that a DCM or SEF may implement to demonstrate compliance with elements of Core Principle 4.15

The DCM rules also set forth risk control requirements for exchanges that provide direct market access (“DMA”) to clients. Regulation 38.607 requires DCMs that permit DMA to have effective systems and controls reasonably designed to facilitate an FCM’s management of financial risk. These systems and controls include automated pre-trade controls through which member FCMs can implement financial risk limits.16 Regulation 38.607 also requires DCMs to implement and enforce rules requiring member FCMs to use these systems and controls.17 Finally, the DCM rules implement new requirements in the Act related to exchanges’ cyber security and system safeguard programs. As with its rule enforcement reviews, the Division also conducts periodic systems safeguards examinations to review DCMs’ compliance with the systems safeguards and cyber security requirements of the Act and Commission regulations. The Act and Commission regulations also address cyber security and system safeguards within SEFs.

The CFTC’s Concept Release on Risk Controls and System Safeguards for Automated Trading Environments

The Commission’s Concept Release on Risk Controls and System Safeguards for Automated Trading Environments was published in the Federal Register on September 12, 2013.18 The initial 90-day comment period closed on December 11, 2013, but was reopened from January 21 through February 14, 2014, in conjunction with a meeting of the CFTC’s Technology Advisory Committee (TAC). As discussed in further detail below, the Concept Release considers a series of potential pre-trade risk controls; post-trade reports; the design, testing, and supervision standards for automated trading systems (ATS) which generate orders for entry into automated markets; market structure initiatives; and other measures designed to reduce risk or improve the functioning of automated markets. The Concept Release also requests public comment on 124 separate questions regarding the necessity and operation of such measures in today’s markets. In this regard, the Concept Release serves as a vehicle to catalogue existing industry practices, determining their efficacy and implementation to date, and evaluating the need for additional measures. The Concept Release is not a proposed rule, but rather a prior step designed to engage a public dialogue and educate the Commission so that it may make an informed determination as to whether rulemaking is necessary and, if so, the substantive requirements of such a rulemaking.

The Commission received a total of 43 public comments on the Concept Release, including comments from DCMs; an array of trading firms; trade associations; public interest groups; members of academia; a U.S. federal reserve bank; and consulting, technology and information service providers in the financial industry. All comments are available on cftc.gov. Many of the comments received are detailed and thorough, including some comment letters that addressed all 124 questions presented in the Concept Release. One commenter conducted a survey of its member firms to gauge existing risk-management practices. Other commenters provided academic papers in support of their points of view, and some focused on elements of the Concept Release that are of particular interest to them. CFTC Staff is studying all comments received and will make initial recommendations once its review is complete.

Fundamentally, the Concept Release asks whether existing risk controls in automated trading environments are sufficient to match the technologies and risks of modern markets. In this regard, the Concept Release focuses on the totality of the automated trading environment, including the progression of orders from the ATSs that generate them, through the clearing firms that guarantee customer orders, and on to execution by registered trading platforms. The Concept Release also addresses ATSs themselves, including their design, testing and supervision. It also raises a number of related issues, ranging from the underlying data streams used by ATSs to inform their trading decisions, to the special considerations involved in trading via direct market access. It also asks whether terms such as “high-frequency trading” should be defined in regulations, and whether HFT firms should be registered with the Commission.

The Concept Release was informed by a number of factors, including: (1) controls or best practices already in use or developed within industry; (2) existing CFTC regulatory standards that address automated trading; and (3) best practices developed by expert groups and outside organizations, including international standard setting bodies, foreign jurisdictions, and the CFTC’s TAC.

The Concept Release begins with an overview of the automated trading environment, including the development of automated order-generating and trade-matching systems; advances in high-speed communication networks; the growth of interconnected automated markets; and the changed role of humans in markets. It also highlights the importance of ATSs as tools for the generation and routing of orders.

These developments are addressed in the Concept Release through a series of 23 potential risk controls and other measures broadly grouped into four categories. The first includes “pre-trade risk controls,” such as controls designed to prevent potential errors or disruptions from reaching trading platforms, or to minimize their impact once they have. Specific pre-trade risk controls include maximum message rates, execution throttles, and maximum order sizes. Depending on the measure, pre-trade risk controls could be applicable to all trading firms; to trading firms operating ATSs; to clearing firms; or to trading platforms. The Concept Release includes a total of eight pre-trade risk controls and sub-controls.

A second category of safeguards includes “post-trade reports” and “other post-trade measures.” Examples in this category include reports that promote the flow of order, trade and position information; uniform trade adjustment or cancellation policies; and standardized error trade reporting obligations. These measures could be applicable to all trading firms; to trading platforms; or to clearing houses. There are a total of five post-trade reports and other measures or sub-measures in this category, including post-order, post-trade, and post-clearing drop copies.

The third category of risk controls discussed in the Concept Release is termed “system safeguards,” including safeguards for the design, testing and supervision of ATSs, as well as measures such as “kill switches” that facilitate emergency intervention in the case of malfunctioning ATSs. Such safeguards would generally be applicable to trading firms operating ATSs, and depending on the control, might also apply to trading platforms and others. The Concept Release presents a total of seven system safeguards, some with subparts.

Finally, the Concept Release presents a fourth category of measures focusing on various options for potentially improving market functioning or structure. These includes measures such as mandatory publication by exchanges of various market quality indicators to help inform market participants (e.g., order to fill ratios; execution speeds for different types of orders and order sizes; price impacts associated with different trade sizes; and average order duration). They also include a number potential measures requiring exchanges to amend their trade matching systems by, for example: (1) providing batch auctions instead of continuous trade matching; (2) prioritizing orders resting in the order book for some minimum period of time; or (3) aggregating multiple small orders from the same legal entity entered contemporaneously at the same price level and assigning them the lowest priority time-stamp of all orders so aggregated.

As a threshold matter, the Concept Release recognizes that orders and trades in automated environments pass through multiple stages in their lifecycle, from order generation, to execution, to clearing, and steps in between. Accordingly, it solicited comment regarding the appropriate stage or stages at which risk controls should be placed. Focal points for the implementation of risk controls described in the Concept Release include: (i) ATSs prior to order submission; (ii) clearing firms; (iii) trading platforms prior to exposing orders to the market; (iv) clearing houses; and (v) other risk control options, such as third-party “hubs” through which orders or order information could flow to uniformly mitigate risks across various platforms. The Concept Release recognizes that the appropriate location of a risk control also may depend on the type of control or its intended purpose. Therefore, it specifically seeks comment on this question, and on the desirability of a “layered” or “defense in depth” approach that places the same or similar risk controls at more than one stage of the order and trade lifecycle.

Given the variety and complexity of matters raised in the Concept Release, commenters understandably held a range of opinions. Many commenters expressed satisfaction that the Commission has undertaken this review of risk controls and system safeguards in automated trading environments. Based on comments received and other indications, a number of parties support certain Commission actions. Some have expressed “race to the bottom” concerns in the absence of minimum regulatory standards. In this regard, any risk controls that introduce latency (i.e., reduce speed) in the generation or transmission of orders could create competitive disadvantage for firms that adopt them unilaterally.

Most commenters also supported a multi-layered approach to risk controls. One commenter stated, for example, that a “holistic approach, with overlapping supervisory obligations, offers the most robust protection by engaging all levels of the supply chain…and eliminating the possibility that a single point of failure will cause significant harm to the market.” Another entity commented with respect to ATS testing and change management that “the same levels of responsibility for testing and change management should apply to all market participants that deploy their own technology, as well as providers of technology that allows access to the markets.”

At the same time, other measures contemplated in the Concept Release drew opposition by a majority of commenters. For example, a majority of parties who commented on the idea of a credit risk control implemented through a centralized hub were opposed to the idea, citing costs, complexity and an undesirable concentration of risk.

Certain key questions in the Concept Release drew very divergent opinions. Commenters disagreed on the need for a regulatory definition of high-frequency trading. Just over half of the parties who commented on this point were opposed to a definition, while the remainder were in favor. The question of defining high-frequency trading is closely related to the question of whether HFT firms not already registered with the Commission in some capacity should be required to register. Those opposed to defining high-frequency trading suggested that no clear distinction can be drawn between automated trading and high-frequency automated trading, or pointed to the difficulty in defining HFT and to the concern that any definition of HFT would become obsolete over time.

A commenter’s opinion as to whether HFT should be defined typically ran in parallel with its opinion as to whether risk controls should apply equally to all automated systems, or whether high-frequency trading or HFT firms deserve special regulatory attention. Those requesting HFT-specific measures logically saw a need to define high-frequency trading. More fundamentally, however, some academic commenters discussed concerns around the speed of trading, including within exchange order books, and suggested steps to slow trading or to reduce any potential advantages that come with speed.

One recurring theme across comments is whether pre-trade risk controls and other measures should focus on high-level principles or be more granular instead. Many industry commenters stated their preference for a principles-based approach to any rules that the Commission may adopt. These commenters argued that prescriptive requirements will become obsolete as technologies advance; may not account for the unique characteristics of market participants; and could result in participants designing around such measures. Similarly, one commenter noted that the best way to achieve standardization of risk controls is through implementing “best practices” developed through working groups of DCMs, FCMs, and other market participants.

Other commenters, however, expressed a need for more prescriptive rules. One argued, for example, that prescriptive rules are necessary unless the Commission receives documentation that the risk controls implemented by firms and exchanges are consistent and effective. Another commenter questioned whether the incentives facing industry participants would permit them to, quote, “sacrifice speed for prudent risk controls.”

Finally, as with the high-level questions discussed above, many of the specific pre-trade risk controls and other safeguards discussed in the Concept Release drew divergent opinions, either around whether the control should be a regulatory requirement or, if a requirement, how granular it should be. Commenters also addressed the appropriate design and use of particular risk controls. For example, one commenter stated that “kill switches, if implemented and used properly, can serve as an effective last-resort means of risk control,” but “are not a panacea and should only be used during extreme events when all other courses of action have been exhausted.” Another commenter specified that kill switches should exist at the trading firm, clearing firm and trading platform level, and that the Commission should assess the methodology used to set kill switch limits.

As noted previously, staff continues to review all comments received and to refine its thoughts. Next steps could include potential recommendations to the Commission for notice and comment rulemaking in one or more areas addressed by the Concept Release.

This concludes my written testimony.

1 See 17 CFR 38.150 (Core Principle 2—Compliance with Rules).

2 See 17 CFR 38.250 (Core Principle 4—Prevention of Market Disruption).

3 See 17 CFR 37.200 (Core Principle 2—Compliance with Rules).

4 See 17 CFR 37.400 (Core Principle 4—Monitoring of Trading and Trade Processing).

5 See 17 CFR 38.152 and 17 CFR 37.203(a).

6 DCMs provide information to the Commission on a “T + 1” basis, i.e., on trade date plus 1.

7 Commission, Final Rule: Ownership and Control Reports, Forms 102/102S, 40/40S, and 71, 77 FR 69177 (Nov. 18, 2013).

8 The Commission further clarified the scope of these prohibited disruptive trading practices in its Interpretive Guidance and Policy Statement on Disruptive Practices. 78 FR 31890 (May 28, 2013).

9 17 CFR 1.73(a)(1) and 23.609(a)(1).

10 17 CFR 1.73(a)(2)(i) and 17 CFR 23.609(a)(2)(i).

11 17 CFR 23.600(d)(9).

12 Commission, Final Rule: Core Principles and Other Requirements for Designated Contract Markets, 77 FR 36612 (Jun. 19, 2012) (the “DCM Final Rules”).

13 17 CFR 38.255.

14 17 CFR 37.405.

15 DCM Final Rules, 77 FR at 36718; Commission, Final Rule: Core Principles and Other Requirements for Swap Execution Facilities, 78 FR 33476, 33601 (June 4, 2013).

16 17 CFR 38.607.

17 Id.

18 Commission, Concept Release on Risk Controls and System Safeguards for Automated Trading Environments, 78 FR 56542 (Sept. 12, 2013).

Last Updated: May 13, 2014

SOFTWARE COMPANY FOUNDERS SETTLE SEC CHARGES OF INSIDER TRADING AHEAD OF SALE

FROM:  SECURITIES AND EXCHANGE COMMISSION 
Three Software Company Founders to Pay $5.8 Million to Settle Charges of Insider Trading Ahead of Sale

The Securities and Exchange Commission filed insider trading charges against three software company founders for taking unfair advantage of incorrect media speculation and analyst reports about the company’s acquisition.

They agreed to pay nearly $5.8 million to settle the SEC’s charges.

The SEC alleges that Lawson Software’s co-chairman Herbert Richard Lawson tipped his brother William Lawson and family friend John Cerullo with nonpublic information about the status of the company’s 2011 merger discussions with Infor Global Solutions, a privately-held software provider. Lawson Software’s stock price had begun to climb following media and analyst reports that the company was considering a sale and multiple bidders were possible. However, Richard Lawson knew reports about possible multiple bidders were incorrect, and the merger share price offered by the lone bidder was significantly lower than what journalists and analysts were speculating. While in possession of the accurate, inside information from his brother, William Lawson sold more than one million shares of his family’s Lawson Software stock holdings. He also suggested that another trader sell shares. Cerullo sold approximately 175,000 of his company shares on the basis of the nonpublic information. When Lawson Software later announced the merger agreement at the lower-than-anticipated share price, the company’s stock value dropped 8.7 percent. By selling their shares at the inflated stock prices prior to the merger announcement, the traders collectively profited by more than $2 million.

According to the SEC’s complaint filed in federal court in San Francisco, Lawson Software was founded by the Lawsons and Cerullo in 1975 and based in St. Paul, Minn. William Lawson and Cerullo each retired in 2001, but Richard Lawson was still serving as co-chairman of the board of directors when the company began considering a possible sale. After Lawson Software and Infor Global Solutions entered into a non-disclosure agreement and met about a possible merger, Richard Lawson and other members of the board were regularly informed about the ongoing merger discussions. While Infor conducted its due diligence in late February 2011, Lawson Software began a “market check” in which its financial adviser reached out to five competitors to gauge their interest in acquiring the company. The market check elicited little-to-no interest, and Richard Lawson and the board were kept informed throughout the process.

Meanwhile, according to the SEC’s complaint, a March 8 article reported that Lawson Software had retained a financial adviser to explore a possible sale. The article identified other companies as potential acquirers of Lawson Software and led to a 13-percent jump in Lawson Software’s stock price that day. The article also fueled widespread - and incorrect - media speculation about potential acquirers of Lawson Software and possible merger prices. Soon thereafter, Lawson Software publicly confirmed an acquisition offer from Infor for $11.25 per share. Nevertheless, ensuing media and analyst reports still incorrectly suggested that other potential purchasers would likely enter the bidding and submit competing higher offers for Lawson Software. Some reports suggested a merger price of up to $15-16 per share. In reality, the same companies being speculated as potential purchasers already had informed Lawson Software that they weren’t interested in an acquisition. But fueled in part by the reports, Lawson Software’s stock price closed at $12.24 per share on March 14 - nearly $1 higher than Infor’s offer of $11.25. The stock price had increased approximately 23 percent since the March 8 article.

The SEC alleges that Richard Lawson knew that these media and analyst reports were inaccurate and the very entities mentioned as possible acquirers had in fact told the company they were not interested. He knew that Infor was the lone bidder and would not increase its offer. Richard Lawson also knew that Lawson Software’s financial adviser and board of directors viewed Infor’s bid as reasonable. After Richard Lawson tipped his brother and Cerullo with nonpublic information about the planned deal, they proceeded to sell their shares at approximately $1 per share higher than the eventual merger price of $11.25. Following the merger announcement on April 26, Lawson Software’s stock price dipped to $11.06 per share at market close. The merger became effective in July 2011.

Richard Lawson agreed to settle the SEC’s charges by paying a penalty of $1,557,384.57 for tipping his brother and Cerullo. The penalty amount is equivalent to the ill-gotten gains received by William Lawson and Cerullo. Richard Lawson also agreed to be barred from serving as an officer or director of a public company. William Lawson agreed to pay disgorgement of $1,853,671.28, prejudgment interest of $162,442.60, and a penalty of $1,853,671.28 for a total of $3,869,785.16. William Lawson’s disgorgement amount includes the ill-gotten gains of the other trader who he suggested sell shares. Cerullo agreed to pay disgorgement of $178,481.29, prejudgment interest of $15,640.81, and a penalty of $178,481.29 for a total of $372,603.39. Without admitting or denying the SEC’s allegations, the Lawsons and Cerullo agreed to the entry of final judgments enjoining them from future violations of Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5. The settlement is subject to court approval.

The SEC’s investigation was conducted by Michael Fuchs and Wendy Kong, and supervised by Josh Felker. The SEC appreciates the assistance of the Options Regulatory Surveillance Authority and the Financial Industry Regulatory Authority.

SEC COMMISSIONER GALLAGHER'S REMARKS ON EVOLVING ROLE OF COMPLIANCE

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION 

Introductory Remarks at The Evolving Role of Compliance in the Securities Industry Presentation

Commissioner Daniel M. Gallagher

Washington, D.C.

May 12, 2014

Thank you, David [Blass].  I’m very pleased to be here this morning to kick off today’s discussion of a timely and critical topic: the evolving role of compliance professionals.  I’d be remiss if I didn’t begin by expressing my thanks to the team responsible for today’s event: Mike Stone, who suggested the event in the first place, our panelists Howard Plotkin and Jerry Baker, and David Blass [and Steve Benham] from the Division of Trading and Markets, who worked with our panelists to put together today’s event.  It’s very heartening to me that there are people like Mike, Howard, and Jerry who are willing to so generously volunteer their time to help the Commission better understand the myriad and complicated challenges facing today’s compliance professionals.  I often speak of the scoundrels and miscreants in the securities industry; it’s a genuine pleasure to be here today with folks from the other end of the spectrum.

In recent years, a variety of factors have combined to significantly expand the scope and complexity of the issues facing compliance officers at securities firms.  Today’s compliance personnel have to address an ever-broadening array of complex and novel financial products, new trading and communication technologies, and multiple, diverse market venues.  They must do so in the face of an unprecedented torrent of new laws and regulations promulgated in response to the financial crisis, most particularly the Compliance Officer and Securities Attorney Full Employment in Perpetuity Act of 2010, or as it’s more commonly known, Dodd-Frank.  

And although securities firms have been generally increasing the amount of resources they devote to compliance matters, compliance budgets have increased in a linear manner while the demands faced by compliance officers have increased exponentially.  A member of the House Financial Services Committee, citing a study issued by the Committee,[1] stated, “It will take over 24 million man hours to comply with Dodd-Frank rules per year.  It took only 20 million to build the Panama Canal.”[2]  On the plus side, at least Dodd-Frank has caused fewer deaths by malaria or yellow fever.

Our system of oversight for regulated entities such as broker-dealers and investment advisers is predicated upon the active participation of compliance personnel.  It is a system of shared responsibility, in which the Commission oversees the firms that, in turn, oversee their associated persons, with SROs providing an additional level of oversight for broker-dealers.  Broker-dealer and investment adviser firms in essence serve as the first line of defense in this system, and the system does not work if firm legal and compliance officers are too timid to jump into the difficult regulatory issues firms face on a regular basis.

All the more important, then, that the Commission does everything in its power to encourage a robust, effective compliance function at the entities we regulate.  This includes, crucially, providing additional certainty on the topic of “failure to supervise” liability.  The Exchange Act vests the Commission with the authority to impose sanctions on a person associated with a broker-dealer if that person “has failed reasonably to supervise, with a view to preventing violations of the provisions of [the securities] statutes, rules, and regulations, another person who commits such a violation, if such other person is subject to his supervision.”[3]  Nearly identical language in the Investment Advisers Act grants the Commission the same authority with respect to associated persons of investment advisers.[4]

The Commission’s ability to impose sanctions for failures to supervise is a valuable part of our regulatory toolkit, encouraging a broker-dealer or investment adviser’s managers and executives to proactively monitor subordinate employees’ compliance with laws and regulations.  We must make sure, however, that our rules establishing failure to supervise liability do not act as a deterrent to in-house legal and compliance officers, discouraging them from departing from their clearly delineated roles.

After all, we don’t want compliance officers or in-house attorneys spending their days drafting policies and sending out memoranda while avoiding interaction with the individuals governed by those policies or the recipients of those memos out of fear of being deemed a supervisor and subjecting themselves to liability.  Indeed, we want to encourage such personnel to bring their expertise to bear in addressing important, real-world compliance issues and in providing real-time advice for concrete problems the firms and their employees face.

To do so, we need to provide guidance that is as clear as possible on our position on supervisory liability for legal and compliance personnel.  In this vein, I was especially pleased when last September, the Division of Trading and Markets, in an effort led by David Blass, issued a set of FAQs on the topic of failure to supervise liability.[5]  The feedback on these FAQs has been very positive, and I hope and expect that we will continue to address new or unsettled issues in this manner.

Events like today's training complement outward-facing initiatives such as the FAQs by providing our own staff with informed and current guidance on compliance issues, and I'm glad to be able to add my enthusiastic support.  Once again, thank you to our panelists, and thanks as well to the SEC staff here today for taking advantage of this wonderful opportunity to learn from our distinguished guests. I wish you all a productive and educational training.


[1] Dodd-Frank Burden Tracker (spreadsheet), House of Representatives Committee on Financial Services, available at http://financialservices.house.gov/uploadedfiles/dodd-frank_pra_spreadsheet_7-9-2012.pdf.

[2] Rep. Randy  Randy Neugebauer, quoted at Dodd-Frank Burden Tracker, House of Representatives Committee on Financial Services, available at http://financialservices.house.gov/burdentracker/default.aspx.

[3] 15 U.S.C. 78o(b)(4)(E)

[4] 15 U.S.C. 80b-3(e)(6).

[5] Frequently Asked Questions about Liability of Compliance and Legal Personnel at Broker-Dealers under Sections 15(b)(4) and 15(b)(6) of the Exchange Act, U.S. Securities and Exchange Commission, Division of Trading and Markets, available at http://www.sec.gov/divisions/marketreg/faq-cco-supervision-093013.htm.

Statement on Jury’s Verdict in Case Against the Wylys:

Statement on Jury’s Verdict in Case Against the Wylys:

SEC CHARGES FRIENDS AND BUSINESS ASSOCIATES OF HOME DIAGNOSTICS, INC., CHAIRMAN IN INSIDER TRADING SCHEME

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION

SEC Charges Three Friends and Business Associates of Former Chairman of Home Diagnostics, Inc., in Insider Trading Scheme

The Securities and Exchange Commission today announced charges against three friends and business associates of the former Chairman of the Board at Home Diagnostics Inc., George H. Holley, for trading on the basis of inside information about an impending acquisition of the company that was illegally tipped to them by Holley.

In Complaints filed in the U.S. District Court in Trenton, New Jersey, the SEC alleges that, in 2010, Holley, who co-founded Home Diagnostics, provided his friends John Campani and John Mullin, and employee Alan Posner, with confidential information about the impending acquisition of Home Diagnostics by Nipro Corporation. Campani, Mullin, and Posner each purchased Home Diagnostics stock on the basis of Holley’s tips for combined profits of more than $105,000. The SEC previously had charged Holley and other tippees with insider trading based on the same material nonpublic information (SEC v. George H. Holley, et al., No. 3:11-cv-00205-MLC-DEA (D.N.J.)).

The SEC’s complaints charge Campani, Mullin, and Posner with violating Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, the general antifraud provisions of the federal securities laws, and Section 14(e) of the Exchange Act and Rule 14e-3 thereunder, the tender offer fraud provisions. Without admitting or denying the allegations in the SEC’s Complaint against him, Campani, Mullin, and Posner each has consented to the entry of a final judgment that permanently enjoins him from future violations of Sections 10(b) and 14(e) of the Securities Exchange Act and Rules 10b-5 and 14e-3 thereunder. In addition, the judgment against Campani will require him to pay $26,700 in disgorgement plus prejudgment interest in the amount of $2,387, and a civil penalty of $13,350; the judgment against Mullin will require him to pay disgorgement of $10,450 plus prejudgment interest in the amount of $896, and a civil penalty of $5,225; and the judgment against Posner will require him to pay disgorgement of $67,910 plus prejudgment interest in the amount of $5,820, and a civil penalty of $33,955. The settlements are subject to approval by the Court.

Campani, Mullin, and Posner cooperated with the U.S. Attorney’s Office for the District of New Jersey in its criminal prosecution of Holley. Holley ultimately pleaded guilty to insider trading. The SEC’s civil action against Holley is continuing.

The SEC thanks the U.S. Attorney’s Office for the District of New Jersey, the Federal Bureau of Investigation, and FINRA, for their cooperation and assistance in this matter.

SEC CHARGES BROUGHT AGAINST HEDGE FUND ADVISORY FIRM FOR DISTRIBUTING FAKED PERFORMANCE RESULTS

FROM:  SECURITIES AND EXCHANGE COMMISSION 

SEC Announces Charges and Asset Freeze Against Hedge Fund Advisory Firm Distributing Falsified Performance Results

The Securities and Exchange Commission filed fraud charges and sought emergency relief on May 5, 2014, against a New York-based investment advisory firm and two executives for distributing falsified performance results to prospective investors in two hedge funds they managed.

The SEC's complaint filed in U.S. District Court for the Southern District of New York alleges that Aphelion Fund Management, LLC's (Aphelion) chief investment officer Vineet Kalucha fraudulently altered an outside audit firm's report reviewing the performance of an investment account he managed. Aphelion's chief financial officer George Palathinkal allegedly learned about Kalucha's falsifications, which essentially changed an investment loss into a major investment gain in the account. Nevertheless, the falsified report showing the phony gain instead of the actual loss was distributed to prospective investors. Furthermore, investors were separately provided false information about Aphelion's assets under management and Kolucha's litigation history.

Kalucha, who is majority owner and managing partner of the firm in addition to chief investment officer, also is charged with siphoning investor proceeds for his luxury car payments and settlements of legal actions against him personally that are unrelated to Aphelion.

In response to the SEC's request for emergency relief for investors, U.S. District Court Judge Jed S. Rakoff issued a temporary restraining order, imposed an asset freeze to protect client assets, and temporarily prohibited the defendants from soliciting new investors or additional investments from existing investors. A hearing on the SEC's motion for a preliminary injunction has been scheduled for May 15 before Judge Richard M. Berman.

According to the complaint, Aphelion serves as the investment adviser and general partner for two unregistered hedge funds: Aphelion US Fund LP and Aphelion Offshore Fund Ltd. Kalucha has been managing investor funds since 2009 using a proprietary investment model that he developed. The outside auditor's report showed an investment loss of more than 3 percent during a 15-month period in an account that Kalucha managed. However, the fraudulent report distributed to investors showed a phony investment gain of 30 percent during an 18-month period. In addition to distributing the altered report, Aphelion, Kalucha, and Palathinkal also misled investors about Aphelion's assets under management. While Kalucha and Palathinkal told investors at various times during 2013 that Aphielion had $15 million or more in assets under management, the firm never had more than $5 million in assets under management at any point during that year.

The complaint further alleges that the defendants misrepresented Kalucha's litigation history to investors. Under the legal proceedings section in a due diligence questionnaire included in Aphelion's marketing materials, Kalucha answered "None" and added a lengthy, materially misleading explanation of a civil proceeding in which he was involved. The proceeding, which he did not identify by name, was a case against him by the U.S. Department of Labor for breaching fiduciary duties. By virtue of a consent judgment in the case, Kalucha and Aphelion are prohibited from acting as investment advisers to many types of common retirement plans, which often invest in hedge funds. Investors were deprived of this information in the due diligence questionnaire.

According to the complaint, Aphelion, Kalucha, and Palathinkal raised $1.5 million in investments for Aphelion from 2013 to March 2014 by representing to investors that the funds would be used for Aphelion's operating expenses. Kalucha actually used more than 40 percent of the funds raised in 2013 for his personal benefit. He has withdrawn investor proceeds for such things as settlement of a foreclosure action involving his personal residence, settlement of a breach of contract action filed against him in his personal capacity, down payment of a luxury BMW sedan, and payment for tax and accounting services for his personal finances. Palathinkal approved all of Kalucha's withdrawals. The complaint alleges that Aphelion, Kalucha, and Palathinkal violated Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. In addition, the complaint alleges that Aphelion and Kalucha violated Sections 206(1), (2) and (4) of the Investment Advisers Act of 1940 and Rule 206(4)-8 thereunder and that Palathinkal aided and abetted these violations.

The SEC's investigation and litigation have been conducted by David Benson, Paul Montoya, Eric Phillips, Delia Helpingstine, Kristine Rodriguez, and Joan Price-McLaughlin of the Chicago Regional Office.