National Futures Association
Compliance Division
300 South Riverside Drive, #1800
Chicago, IL 60606
Submitted via Email & Website
re: Request for Comments – CTA/ CPO Capital Requirement and Customer Protection Measures
Dear Sir or Madame:
We appreciate the opportunity to provide the NFA staff with the comments and recommendations set forth below in response to Notice I-14-03: Request for Comments CTA/CPO Capital Requirements and Customer Protection Measures.
Introduction
Since the collapse of MF Global, we have been stedfastly committed to strengthening investor protections. We are working with various groups on initiatives to shore up customer protections via legislative action, regulatory reform and market innovation. We believe the NFA should focus first on the protection of customer property held by its members and second on the prevention of all manner of fraud through the enforcement of its rules.
It is because of our commitment to enhance customer protections that we do not favor enacting capital requirements on CTA or CPO members of NFA. Enacting capital requirements for CTAs and CPOs would impose a costly compliance burden on emerging managers, stifling competition, innovation and growth in managed futures as an asset class. In exchange for that burden, customers would incur higher trading costs and receive little in the way of an effective deterrent to fraud.
There is no evidence that capital requirements are an effective means to prevent or deter nonfeasance, misfeasance or malfeasance. In fact, capital requirements may actually provide an inducement for members to raise assets through fraud. Capital requirements did not prevent or help detect the loss of customer property from malfeasance at Peregrine Financial Group. Nor did capital requirements stop losses to customer property incurred by Griffin Trading, MF Global or Sentinel Management Group–especially considering the fact that Sentinel was able to opt out of net capital requirements (and change the way they calculated their net capital) by way of a no-action letter from the CFTC.
What ultimately uncovered the fraud at Peregrine, and what may prevent future theft of customer property, is NFA’s new electronic balance confirmation system for FCMs. NFA should focus its efforts on successfully implementing regulatory measures like this one, utilizing technology to enhance customer protections and minimize the cost of compliance. To this end, and as an alternative to a net capital rule for CTAs and CPOs, we recommend that NFA staff and the CTA/CPO Advisory Committee consider the following:
For CTA Members, a surety or fiduciary bond requirement. A surety bond provides a source of recourse for investors in the case of malfeasance, while not imposing an undue compliance burden on CTAs who pose little theft risk to customer property. This recourse comes from an independent third-party, rather than through the CTA itself, making it much harder for a rogue CTA to impinge on the source of recovery for aggrieved customers.
For CPO Members, a choice between using an independent third-party administrator for disbursements or electronic confirmation of bank, FCM account balances and transparent assets with monthly reporting of NAV to NFA. The use of a third party administrator and custodian provides a layer of separation and control between the CPO and customer property. It introduces a measure of checks and balances over the disbursement of that property and would be less costly for firms to implement than net capital rules. Large pools who cannot implement this kind of system could be permitted to opt out of they agree to enhanced reporting requirements, including: daily confirmation of FCM and bank account balances, daily or periodic confirmation of transparent assets (securities, OTC products, etc) and monthly reporting of NAV to NFA.
We encourage the NFA, its committees and advisors, as well as the industry to consider these proposals in lieu of capital requirements.
Our Analysis of MRAs
In the request for comment, NFA staff noted that the last three years have seen the issuance of 26 Member Responsibility Actions (“MRAs”), 92% of which involved firms which maintained a registration as a CTA or a CPO. We thought it would be instructive to broaden this analysis and look at as much of the history of MRAs as is available.
We analyzed all publicly searchable Member Responsibility Actions (“MRAs”), which includes all MRAs issued from 1998 to 2013 and all those available between 1996 and 1998. In the data available for this 18 year period, there were a total of 87 cases which resulted in the issuance of an MRA.
MRAs by Year, 1996 – 2013
(Click to view in separate window)
The data show that MRAs are on the rise, with an average of 2.6 MRAs per year in the 10 year period from 1996 to 2006 tripling to about 8 per year in the period from from 2007 to 2013. This increase correlates with the recent rapid increase of CTA/CPO members, as well as the financial crisis.
About 68% of MRAs issued in the analyzed period included firms which maintained a registration as a CTA or CPO, with about 58% coming from firms with only CTA or CPO registrations. As a group, firms which maintained only a CTA registration had the second lowest instance of MRAs by registration (about 9%).
MRAs by Registrant, 1996 – 2013
(Click to view in separate window)
In addition to these MRAs, the NFA issued complaints for seven cases of theft of customer property and six cases of ‘fraud and related matters’ which did not have corresponding MRAs. A spreadsheet of the data we compiled and analyzed is available at this link.
The data shows that registrants in the CTA category do not pose as significant a threat to customer property as CPO registrants. Most of the cases in which MRAs were issued against CTAs were due to the use of misleading or false return information. While those are instances of very serious fraud, they do not constitute the direct threat of theft of customer property. In the few cases where customer property was misappropriated by a CTA registrant, it was through the use of an unregistered pool, direct acceptance of customer funds or through the misappropriation of APS credits. Clearly, custody of customer property is the salient driver of its theft. Dual-registered CTA/CPO members present a higher risk for fraud than CTA-only firms.
Capital Requirements for CTAs
The Question of Fiduciary Duty & Going Concerns
While CTAs are not explicitly required to abide by the standards of a fiduciary, CTAs assume certain fiduciary duties by accepting discretionary trading authority over separately managed accounts. This relationship is controlled by a limited and revocable power of attorney, governed by the agreement between the CTA and customer and granting only the power to affect certain types transactions on a customer’s behalf. Therefore, the fiduciary duty created by this power of attorney is also limited. One question which arises from the NFA’s request for comment is, does this limited implied fiduciary duty impose a responsibility on the part of the CTA to maintain sufficient assets to remain a going concern?
We contend that the answer is no. The duty owed to customers by the CTA is not derived from the CTA’s assets or financial position, no more than the fiduciary relationship between a doctor and patient rests on that. Instead, the the CTA owes each customer a professional standard of care, to act in the customer’s best interest, carry out its duties prudently and make adequate disclosures to the customer of risks, conflicts of interest, etc. The CTA custodies no customer assets and customers do not maintain an ownership interest in the CTA’s business. If the CTA were to become insolvent and forced to liquidate its assets to pay creditors, the accounts over which that CTA maintains power of attorney would not be creditors the CTA’s firm. In and of itself, the implied fiduciary duty of the power of attorney is not reason enough to require a level of net capital.
Moreover, imposing a capital requirement is more likely to have the unintended effect of incentivizing practices in direct conflict with a CTA’s implied fiduciary duty. In order to raise assets to comply with capital requirements, CTAs are likely to raise fees or engage in sharing in commissions. These practices begin to raise conflicts of interest between the CTA and his customer which would do greater harm to more customers than the problems which are purportedly prevented by imposing a capital requirement. NFA audits of CTA and CPO members focus heavily on these members’ financial condition and practices, which offers NFA the occasion to oversee the financial stability of CTA members without perverting incentives for these members to remain in compliance.
Even if one thinks there are other reasons for a CTA to be required to maintain a prescribed net capital level as a means to be a ‘going concern,’ we fail to see how a capital requirement promotes that. There are non-financial factors which are more likely to cause a CTA to cease to be a going concern which cannot be effectively addressed through regulation. For example, many emerging managers are exposed to key personnel risk stemming from trading strategy intellectual property being maintained by a few key personnel. It is much more likely that a firm would fail to be a going concern, in the sense that it would be unable to fulfill its contractual obligations to its customers, if such key personnel are incapacitated. Even though NFA has imposed requirements for CTAs to maintain business continuity and disaster recovery plans, these do not address all key personnel risk and neither do capital requirements. Backstopping this is the FCM, which essentially acts as a third party administrator for the customer. Should a CTA be unable to fulfill its duties for whatever reason, the FCM can liquidate a customer’s positions and let me customer resume control of his or her trading account.
Net Capital Rules Would Not Carry More Weight Than Existing Federal Laws
In its request for comment, NFA staff highlight a case in which a CPO member improperly used pool funds for its own purposes as it had insufficient assets to continue operations as a going concern. It is unclear exactly how capital requirements would prevent this. Misappropriating customer property for pool or personal expenses is already against the NFA rules, as well as federal law. A CTA or CPO member who is willing to embezzle or otherwise illegally convert customer property for its own use is unlikely to be deterred by the addition of capital requirements. In fact, compliance with such rules may push such members into committing fraud in order to have the capital to comply with NFA rules.
An Extremely Costly Burden
A capital requirement for CTAs would necessitate a regulatory mechanism to test compliance with that requirement. This would mostly likely mirror the process in place to test FCM and IB compliance with capital requirements. As such, CTA members would be required to submit bi-annual financial statements and annual certified audits of financial statements. The cost to maintain and file these statements and audit is high and burdens small and emerging managers the most. Those who seek to utilize fraud would still be able to, while members who want to be in compliance would see their costs go up–all while customers are no better protected than they are now.
Capital Requirements for CPOs
On the surface, a net capital requirement for CPO members makes sense. After all, these members custody customer property. Customers of CPOs are general creditors in a bankruptcy proceeding of an insolvent commodity pool as they have ownership interest in the pool. As evidenced by NFA data, CPOs are the largest plurality of cases involving fraud or theft of customer property. However, we do not believe that a net capital requirement is in the best interests of protecting customer property or allocating NFA’s regulatory assets.
The CTA/CPO industry relies on managing assets well in excess of the asset management firm’s own assets in order to generate sufficient cash flow to fund the operations and staff required to manage those assets. Generally, if a firm has a large enough balance sheet to conduct all of these operations solely for its own capital, it does not need to undergo the additional costs and burdens of NFA registration, it simply uses a proprietary firm or family office exemption. Moreover, even if pool participants are general creditors of an insolvent pool, they are not general creditors of the CPO itself due to the limited liability protections inherent in pools. Thus, even if a CPO had substantial capital on its own balance sheet, pool participants would not be entitled to said capital in the event of a pool insolvency unless a bankruptcy court were to find fraud to have occurred. Therefore, there is little value add to pool customers should a CPO be forced to meet capital requirements.
The Concern of Going Concerns
As noted above, there have been instances in which CPOs have unlawfully converted pool assets for their own use because they did not otherwise have the resources to continue operations. Even if net capital rules offer a measure of prevention for this motivation–which is far from proven–a Member that would consider unlawful conversion as an acceptable business practice and is not deterred by prison will not be deterred by net capital rules.
Alternatives to Capital Requirements
NFA should focus its efforts on solutions which offer the greatest measure of prevention. In our opinion, this would result from adding a layer of controls between customer property and the CPO, with enhanced reporting requirements to help detect potential threats before they become large property losses.
Requirement to Use a Third-Party Administrator and Custodian
The majority of MRAs and fraud cases brought against commodity pool operators have been against small (less than $20M in assets), often single person shops, who simply use the pool bank account as a slush fund. Industry-standard practice for pools in which institutional investors participate is to use a third-party administrator and custodian. Such an arrangement puts two independent third-parties on notice that the funds being held in the pool belong to a regulated commodity pool and require three parties to approve cash disbursements. These independent checks and balances make it virtually impossible for a pool operator to steal funds without at least one of the two independent parties to be negligent or complicit in the fraud. This greatly reduces the potential for and magnitude of fraud, and raises the prospects of recovery should a well-funded bank or administrator be the aggrieving second party. An ounce of prevention is worth a pound of cure. This method of securing funds is the one of the only proactive approaches being considered at this time. Even with daily balance checks, a CPO without an independent administrator and custodian could simply wire the full bank balance of a pool from his or her cell phone at end of day from a foreign country and never been seen again. Only through proper controls on the transfer of cash can you actually prevent theft.
Daily Electronic Bank, FCM Balance & Other Asset Confirmation with Monthly NAV Reporting
Large pools, which have a high volume of transactions, may find a requirement to use a third-party administrator and custodian operationally difficult. NFA may consider an option where large or complex CPOs have enhanced reporting requirements in the place of a third party administrator and custodian. This would mean building on the infrastructure NFA has already constructed with the CME to report bank and FCM account balances and expanding that to other asset classes.
Given the broad spectrum of assets in which a pool may invest, such a reporting scheme would be difficult to design and implement. That does not mean that it is impossible. Even if such a mechanism only captured a portion of the assets held by a CPO, that information would still be useful in the detection of fraud. It would also be provide useful metrics to inform NFA auditors as to where they should be focusing their attention.
Enhance Reporting by Building a Data Repository for Asset Reporting
Most asset custodians offer some kind of electronic confirmation of the assets they hold in trust. Ownership of exchange traded securities and derivatives is easy to confirm. A wide variety of application programming interfaces (“APIs”) and data feeds exist for these asset classes. Many OTC assets are just as easily matched to managers via trade data aggregation services like Triana. Pools which engage in credit default swaps, repurchase agreements, commercial paper, OTC FX and cash equities can report them via these services. Less transparent assets like real estate and private placements may have to be self reported and, perhaps as a result, draw more scrutiny from NFA auditors. NFA will need to build a simple repository for this data and script the mechanism which matches transactions and assets to pools. It is certainly a daunting project, but it is doable and would truly be an innovation worthy of NFA’s motto.
Surety or Fiduciary Bond or Requirements for CTAs
While we believe that net capital requirements to be overly burdensome and provide little protection for customers, surety or fiduciary bonds are a cost effective means to provide customers with financial recourse in the event of malfeasance. Many states impose surety bond requirements of Registered Investment Advisors as an alternative to net worth or net capital rules. The exact type of bond, and the scope and amount of coverage required are subjects for study.
Inactive CTA/CPO Members
In Notice I-14-03, NFA also requested comment on the status of hundreds of ‘inactive’ CTA/CPO members that do not engage in commodity trading. In our virtual town hall, the definition of these members was clarified as those who do not engage in trading commodity interests and reply ‘no’ to the question on their annual questionnaire which asks if they are ‘actively soliciting for customers’. NFA’s concern is that it wastes valuable resources in regulating these members and bears reputational risk from the actions of these members that it might be able to shed by narrowing the qualifications for active membership in the NFA.
We believe the current standards used to delineate active membership are sufficient. Members pay dues which should adequately fund NFA’s ability to oversee them under the current cost structure, especially if audits of firms with limited activities are conducted in an expedited fashion, as opposed to periods as long as 6 months for many more active Members. The question of reputational risk is overwrought and largely one mitigated by proper public relations. It is hard to imagine Members who do not trade or manage money having the capacity to damage NFA’s reputation on the scale of Peregrine or AlphaMetrix.
Conclusion
We think customer protections are paramount to the industry. There is much to be done in the wake of recent FCM failures and cosmic scale ponzi schemes. We salute the NFA for its proactive approach to protecting customer property and for soliciting input from its membership, industry stakeholders and the investing public. However, we cannot support regulation that does not meaningfully solve the problems it was meant to fix. We think that our proposals above offer greater protections to customers at a lower cost to Members. We encourage NFA staff and the CTA/CPO Advisory Committee to add these proposals to the measures they will study to enhance investor protections.
In our preparation to respond to Notice I-14-03, we conducted a virtual town hall for CTA/CPO representatives and received a great deal of correspondence from registered CTAs, CPOs and IBs, as well as industry service providers and the investing public. We would like to thank all of you for your thoughts, comments and participation. We would also like to thank NFA’s General Counsel, Tom Sexton, for participating in our virtual town hall meeting. His service to the membership is greatly appreciated.
Respectfully Submitted,
By Gregory Meyer in New York and Neil Munshi in Chicago
Government-authorised insurance for customers of collapsed futures brokers would take half a century to become fully funded, requiring a taxpayer backstop in the interim, an industry-backed study has found.
The conclusion is ominous for the creation of a futures market version of the Securities Investor Protection Corporation, which covers up to $500,000 in losses suffered by US stock investors if their broker fails.
The study was commissioned in November 2012, after a year in which the collapse of brokers MF Global and Peregrine Financial Group shook traders’ faith in the safety of futures markets.
More than $1bn in customer collateral held by MF Global went missing in the broker’s chaotic final days in October 2011. At Peregrine $200m vanished in a fraud.
In the aftermath traders advocated the creation of an insurance fund like SIPC, which Congress authorised in 1970.
The futures study, whose sponsors included futures exchange operator CME Group, the National Futures Association self-regulatory body and the Futures Industry Association, examined the viability of a “Futures Insurance and Customer Protection Corporation” similar to SIPC.
The corporation would cover up to $250,000 per customer and be funded by a 0.5 per cent annual assessment on futures brokers’ gross revenue.
Assuming no payouts, the corporation would take about 55 years to reach a target funding level of $2.5bn.
“A universal government-mandated solution would take a long time to fund,” said Christopher Culp, who led the team of study authors.
A US regulator who supports an insurance scheme cast doubt on the conclusions. “Look, firms don’t want to pay for an insurance pool to protect customers,” said Bart Chilton of the Commodity Futures Trading Commission. “Now we have a study funded by those guys that gives reasons why it’s a bad idea. I’m certainly not shocked.”
An alternative plan involving a private insurance company owned by futures brokers and backed by reinsurers stoked interest from a syndicate of eight reinsurance companies. The syndicate proposed covering up to $300m in claims, with participating brokers bearing the first $50m in losses.
The cost, estimated at $18m-$27m per year, was deemed “restrictive” but the study indicated that brokers might be able to negotiate a better rate.
Gary DeWaal, a consultant and former general counsel at Newedge, the futures broker, said that the government-mandated alternative appeared “dead on arrival”. “The problem is it would just take an eternity to come up with a useful level [of funds],” he said. “I can’t imagine there’s any appetite in the federal government to provide a loan if there was a blow-up in the interim.”
John Roe, an NFA board member who heads a group advocating for former MF Global customers, said that the industry is clamouring for some sort of customer account insurance.
“The pricing is going to be the rub here – you’re going to have to have a big enough field of folks here to bring the costs down to make it effective,” he said.
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By Christine Stebbins
(Reuters) – Two years ago on Halloween thousands of U.S. grain farmers got the scare of their lives when broker MF Global collapsed and more than a billion dollars of their money went missing.
MF Global customers have now, through a court-appointed trustee, recovered about 98 percent of the money, which had been in supposedly “safe” margin accounts. The balance is expected by year’s end.
The U.S. futures industry has also stepped up its audit trails of customer accounts at brokerages and banks and required more regulatory paperwork.
All that has been a treat for MF Global customers. But looking back at Thursday’s anniversary of the debacle, U.S. grain hedgers fear there is little assurance they won’t be tricked again. What is haunting them is that, lacking realistic alternatives, they must still use the U.S. futures market and futures commission merchants (FCMs)to hedge price risks.
“They really don’t have an alternative,” said Dave Smoldt, vice president of grains and oilseedsbusiness for Intl FCStone, one of the firms that has picked up some former MF Global customers. “If you take in 13-14 million bushels of grain in 30 days, somebody has to hold on to it. So you’re going to have to hedge it.”
Jim Berg, an Ohio farmer and veteran commodities broker, agrees.
“Nobody is doing anything different. Maybe keeping the amount of excess margin down at houses,” Berg said. “We need the markets. We’re alright until the next violation. The next time, the trust is broken.”
That makes many farmers and brokers who trusted MF Global very nervous.
They say little has changed fundamentally to prevent another mega-broker bankruptcy. There has been no reform of the bankruptcy laws that protect customer funds. The futures industry has yet to establish an insurance fund to reimburse customers in cases of malfeasance or fraud by brokers. And no one at MF Global, they point out bitterly, has ever been charged with any wrongdoing.
“Customers still don’t have 100 percent of their funds yet from MF Global,” said John Roe, one of the founders of the Commodity Customer Coalition, which works to recover MF funds.
“While there are additional protections to customers and regulations that will make this more difficult to do, that doesn’t mean it can’t be done again, and it certainly doesn’t mean it won’t happen again.”
Confidence in regulators got another blow on Wednesday, when the Commodity Futures Trading Commission voted new rules to protect customers, but included a provision that will likely mean a doubling in the margin required for “safe” segregated funds, the very type diverted by MF Global two years ago.
“By requiring farmers and ranchers to pre-fund their margin requirements, they would be forced to do something they would rather not do, which is put more money at an FCM rather than less,” Gerry Corcoran, chief executive of RJ O’Brien, the largest independent U.S. commodities brokerage, said in an interview.
The Commodity Customer Coalition’s Roe echoes that sentiment.
“What the CFTC has basically done through the residual interest rule is ask customers to double down on a system they don’t trust,” said Roe, who was also an MF Global customer.
GHOST OF HOLLOWEEN PAST
On October 31, 2011, the global commodities brokerage run by Jon Corzine, a former New Jersey governor and U.S. senator, and a former Goldman Sachs Group Inc (GS.N) chairman, suddenly filed for bankruptcy, freezing more than 150,000 accounts worldwide.
Investigators later discovered that, in order to cover exposure to risky European sovereign debt, MF Global had in its hectic final days improperly tapped segregated customer funds. This was money put into accounts by MF Global customers as good faith deposits to settle their own trades.
The collapse raised questions about not just government regulators, but the clearing houses of the markets themselves, centered on the CME Group Inc (CME.O) markets. It was an unprecedented loss of “safe” customer funds.
Agricultural hedgers – country grain elevator operators, livestock producers, ethanol makers, farmers and ranchers – were among the hardest hit since MF Global, which had grown through acquisitions, including such major players as Refco, cleared the bulk of their business.
“MF was one of the biggest. We thought it couldn’t go down. When it did, it created a lack of trust in any other house you cleared through,” said J.B. Daughenbaugh, a merchandiser with Alliance Grain in Gibson City, Illinois.
The good news since the collapse is that the futures industry has beefed up regulations on how segregated funds are invested. Brokerages must now have written rules governing the maintenance of such funds. Top executives at brokerages must personally approve withdrawals of 25 percent or more from customer funds. Banks must also confirm daily segregated funds in cross checks with brokerage accounts.
But despite all the improvements, grain hedgers are still haunted by the ghost of MF Global.
“The number one thing that has not been done is to insert the Commodity Exchange Act verbiage into the bankruptcy code so segregated fund restoration to customers comes first in an FCM liquidation,” said Jeff Hainline, head of Advance Trading, which cleared hundreds of customer accounts through MF.
]]>By Dan Strumpf and Jerry A. DiColo
The civil charges levied Thursday againstJon Corzine for his alleged role in the collapse MF Global Holdings Inc. were a welcome development for many former customers of the firm.
But Lonnie Becker, a farmer who held an MF Global account, is just glad he’s getting his money back.
Like many farmers, Mr. Becker relied on MF Global to hedge the price of his crops and livestock. His farm in Fairmont, Minn., grows corn and soybeans on 1,800 acres and also raises hogs. When MF Global collapsed in October 2011, the money in his account — he declined to say how much — froze up for a week. He has gotten most of his money back, but in the meantime, he has had to take out loans from his bank to cover his farm’s costs.
“It’s been a long couple of years, but it sounds like we’re gonna get paid up,” he said.
Today, all of MF Global’s U.S. customers have received 89% of their lost funds. And on Thursday the Commodity Futures Trading Commission said customers will receive 100% of their money in a deal involving a settlement of charges with MF Global.
The news of the government’s lawsuit against Mr. Corzine hadn’t yet reached Mr. Becker on Friday — he was on his way to Chicago for his son’s AAU baseball game — but it’s of secondary importance to him anyway. The fate of his farm is more important, and he’s been encouraged by the slow-but-steady return of the money he needs to support it.
“There’s nothing but good news here lately,” he said.
John Roe, co-founder of the Commodity Customer Coalition, which has advocated for MF Global customers since the firm collapsed, said this week has marked a turning point in the group’s efforts.
“The landscape has really changed since yesterday,” said Mr. Roe, who is also a partner at Chicago-based BTR Trading. “”If everything goes according to plan, customers should be receiving 100% of both their foreign and U.S. accounts by the end of September.”
Nearly $1 billion in customer money went missing after MF Global collapsed under the weight of big leveraged bets on European debt. Regulators allege that the firm dipped into customer money to fund its final days before its collapse. Some customers say civil charges against the firm’s leaders don’t go far enough.
Scott Gettleman, an independent trader on the Nymex, lost $102,000 when MF Global imploded. He’s received 89% of his funds and was glad to hear the full amount would likely be coming soon—but he’s still hoping Mr. Corzine is brought up on criminal charges, or forced to compensate customers through a class-action lawsuit.
“Everybody is ecstatic to get their money back. It’s been a long haul. But you also want to see someone punished for this type of behavior,” he said. “If a normal person ran around and did this stuff, they’d be in jail.”
]]>By Tom Polansek and Ann Saphir
CHICAGO/SAN FRANCISCO (Reuters) – A North Carolina hedge fund manager used a personal post-office box and forged bank statements to hide his theft of about $6 million over a seven-year period, U.S. regulators and prosecutors said on Monday.
James Shepherd, who ran a commodity fund that traded contracts at CME Group Inc (CME.O) and IntercontinentalExchange Inc (ICE.N), was charged with the fraud in federal court in Charlotte on Monday. In a related action, the Commodity Futures Trading Commission sued Shepherd for fraud and misuse of customer funds.
The charges were reminiscent of a larger scam uncovered last year that was perpetrated by Russell Wasendorf Sr., the founder of Peregrine Financial Group. He used similar tools to steal $215 million from clients over nearly 20 years.
Shepherd’s alleged swindle lays bare the ongoing challenges of policing the vast hedge fund and commodity pool industry, much of which has come under additional regulation since January through the National Futures Association (NFA) trade group.
Shepherd entered a sealed plea agreement in the criminal case.
“He definitely wants to pay back people who have lost money,” his lawyer, John Keating Wiles, told Reuters.
Peregrine last July filed for bankruptcy after the 20-year-long fraud came to light. Wasendorf, 65, is serving a 50-year sentence in federal prison after admitting to stealing from customers and lying to regulators.
After Peregrine’s collapse, NFA and other futures regulators put in place a system of electronic confirmations that allows daily checks of the $157 billion or so of customer funds kept at futures brokerages.
Such a system is currently not possible for tracking money kept at hedge funds, where much more money is at stake, NFA President and Chief Executive Dan Roth said in an interview.
Unlike futures brokerages, which keep customer money in a limited set of financial institutions, commodity pools can put their money at broker-dealers, in real estate, in oil wells, and in any number of other places, Roth said.
“They can invest in a gazillion things,” Roth said.
The NFA is exploring ways to electronically keep tabs on the money at the commodity pools it oversees, but it’s a complicated undertaking.
“It’s a significant priority for us,” he said, “but I don’t know as I sit here that we will have a solution implemented by the end of the year, or anything like that.”
$300 BILLION POOL
At the end of 2012, NFA oversaw about 2,500 commodity pools with a total of $300 billion under management. New registration requirements that kicked in this year have pushed up the number of NFA-regulated commodity pools to 8,000, and NFA has yet to put a figure on total amount managed.
The complaints filed on Monday against Shepherd revealed new details about his fraud, including the use of a personal post-office box that he told his auditor and regulator was the property of his bank. Shepherd spent some of the misappropriated money to build a $2 million home in Vass, North Carolina, U.S. prosecutors said.
Shepherd’s fraud unraveled in March after his accountant insisted the fund’s bank balances be confirmed electronically through a website called Confirmation.com. Shepherd refused and the accountant alerted NFA.
NFA and CFTC declined to name the accountant.
The NFA shut down Shepherd’s fund after its investigators could not locate millions of dollars he claimed to have.
“Where there’s a paper process that’s very easy to manipulate, you’re going to have people that do that,” said Brian Fox, founder of Confirmation.com. The site also was used to help uncover Wasendorf’s fraud.
Since March, NFA has combed through the records of all 8,000 commodity pools that it regulates to confirm that all post-office boxes to which it was sending requests for bank statement confirmations actually belonged to banks. The review found no new fake post-office boxes, Roth said.
While both Wasendorf and Shepherd used P.O. boxes, they differed in their relationships with clients. Shepherd’s customers trusted him to invest their money, while Wasendorf was not making investment decisions.
Shepherd’s fraud is “what Madoff did on a much smaller scale,” said John Roe, co-founder of the Commodity Customer Coalition, which has helped former Peregrine customers get their money back.
Bernard Madoff pleaded guilty in 2009 to running a multibillion-dollar Ponzi scheme and is serving a 150-year sentence in a medium-security North Carolina federal prison.
(Reporting by Tom Polansek and Ann Saphir; Editing by Richard Chang)
]]>By Tracy Alloway in New York and Neil Munshi in Chicago
The US regulator charged with overseeing MF Global is planning to file a civil suit against Jon Corzine, the former chief executive of the collapsed brokerage.
The Commodity Futures Trading Commission (CFTC) is likely to allege that Mr Corzine was “negligent in failing to supervise” the staff who worked in MF Global’s office in Chicago, said a spokesman for the former CEO and New Jersey governor.
The commission may also file a civil suit against Edith O’Brien, a former assistant treasurer at MF Global who emerged as a key witness in determining what happened at the firm, according to a person familiar with the potential legal action.
MF Global collapsed in October 2011, sending shockwaves across Wall Street and leaving a $1.6bn hole in customer funds after allegedly dipping into clients’ accounts to make up for part of its own funding shortfall.
Successful litigation by the CFTC against executives at a failed financial group would be a rare win for the US government agency, which has struggled to hold senior bankers to account for alleged misbehaviour in recent years.
Mr Corzine’s spokesman said the former chief executive “would welcome the opportunity to litigate this matter in an impartial venue”, potentially setting the stage for a drawn-out court battle. If the CFTC’s lawsuit proves successful, Mr Corzine could face millions of dollars worth of fines as well as a ban on trading commodities.
“The CFTC apparently intends to bring what would be an unprecedented and meritless civil enforcement action against Mr Corzine,” the spokesman said.
“There is no legal or factual basis for the CFTC’s attempt to blame Mr Corzine for alleged mishandling of customer funds in the last days of MF Global.”
MF Global declared bankruptcy after making billions of dollars worth of wrong-way bets on eurozone government debt. Shortly before its bankruptcy, the company transferred $200m from one of its customer accounts to cover a $175m overdraft, according to a government report.
The company’s failure triggered a complicated cross-border bankruptcy proceeding, with some clients still waiting to recoup their money.
John Roe, a manager of the Chicago-based futures company BTR Trading Group and an outspoken critic of Mr Corzine, said: “We’re glad the Department of Justice has allowed the CFTC to act, and I’m hopeful a civil suit [will] go a long way towards discouraging this type of activity.”
Mr Roe, whose customers had about $20m in accounts with MF Global, has pushed for Mr Corzine and other executives to be held legally accountable for the brokerage’s failure.
Mr Corzine has strenuously denied instructing his employees to make the funds transfer, and the CFTC’s legal action is therefore likely to focus on his alleged failure to supervise employees, rather than improper use of customer funds.
Mr Corzine, who is also a former chief executive of Goldman Sachs, has already appeared before a special congressional committee to defend his role in the broker’s failure. Edith O’Brien, the former assistant treasurer, refused to give evidence to the same congressional inquiry. She has received a notice informing her of potential legal action from the CFTC, the person familiar said.
A spokesman for the CFTC declined to comment, as did Ms O’Brien’s lawyer.
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By Lynne Marek
When people ask Michael Mason, a trader in the lumber pit of the Chicago Mercantile Exchange, why he’s wearing a flimsy temporary trading badge, he says it’s a reminder that MF Global Inc. still owes him money.
He once used MF Global to help execute his trades—with a badge that displayed that relationship—until the futures broker failed almost overnight, swallowing $1.6 billion in customer money that was supposed to be in protected accounts. “They stole it,” says Mr. Mason, who’s out $10,000. “It shouldn’t have happened.”
And then it happened again. The collapse of MF Global in 2011 was followed the next year by the equally surprising demise of Peregrine Financial Group Inc., whose 13,000 customers lost approximately $215 million. While futures market regulators repeatedly had disciplined both companies—New York-based MF Global had more violations than any other in the previous five years—they not only failed to prevent the biggest scandals in decades, but critics say the system hasn’t evolved adequately to confront changes in the market.
Crain’s reviewed five years of enforcement action by the two day-to-day regulators of the futures markets—CME Group Inc., which owns and operates exchanges including the CME, and the National Futures Association—the first comprehensive media report on the data. Among the findings:
• Actions against firms like MF Global and Cedar Falls, Iowa-based Peregrine, the entities that deal with customer money, accounted for only a small percentage of regulatory cases.
• The overall caseload has plummeted even as trading volume is growing.
• Especially at CME, regulators prefer to fine violators and allow them to continue to operate, rarely turning to harsher punishments even for repeat offenders.
In addition, while both organizations are overseen by the federal Commodity Futures Trading Commission, they often act like private clubs, meting out discipline with little transparency. CME even refuses to disclose the names of many companies responsible for a significant percentage of its trading.
For an industry like the futures industry that has always been known as safe and sound as far as segregated (customer) funds go, maybe we have taken that too much for granted,” says outgoing CFTC Commissioner Jill Sommers, who used to work as a lobbyist for CME. “Maybe it took those situations to show the rules are antiquated, how technology has to be integrated into policing the industry and how we can do these things more effectively and efficiently.”
CME and NFA say they have been vigilant in their oversight, kept pace with the industry’s electronic evolution and responded to the broker crises.
“Nothing is more important than the confidence customers have in our marketplace and the protection of our customers, and I think that’s underscored by the action and the leadership action that we’ve undertaken over the years to historically build up comprehensive surveillance and monitoring programs,” CME Chief Operating Officer Bryan Durkin says. The for-profit company operates the world’s largest futures exchange, audits large futures commission merchants, or FCMs, such as MF Global, and polices its own trading floors.
Chicago-based NFA, an industry-funded nonprofit that registers participants in the U.S. futures markets, has oversight over smaller brokers like Peregrine and a variety of other industry players. NFA President Daniel Roth says the scandals have driven his organization to rethink its enforcement procedures. “It’s an ongoing process, but, yes, I think we’ve made huge changes as a result of Peregrine and MF Global,” he says.
REPEAT OFFENDERS
CME and NFA were well- acquainted with MF Global and Peregrine by the time the two firms collapsed. Crain’s review found that MF Global chalked up 20 offenses in the five years before it liquidated—more than any other firm or person in the CME database. And disciplinary actions over that span weren’t aberrations: MF Global was fined $10 million by the CFTC in 2009 for supervisory oversights between 2003 and 2008.
Peregrine was dinged six times by NFA and CFTC between 1996 and its demise. That included an unusually large $700,000 fine NFA assessed Peregrine in February 2012 for working with brokers who put their desire to maximize trading commissions over customer interests.
The enforcement data show that actions against futures commission merchants like MF Global and Peregrine, which are responsible for customer funds, generally accounted for about 15 percent or less of cases annually, though that percentage rose in the wake of the two failures, jumping to 30 percent at CME last year. At the same time, seven of CME’s nine biggest repeat offenders were approved to act as FCMs (although some of them play multiple roles on the exchanges).
The enforcement data also point to a system that largely has been focused on the trading pits and hasn’t changed dramatically as most trading has moved online.
The pits have been shrinking over the past decade, leaving just about 10 percent of overall trading in “open outcry” today. Over the same period, U.S. volume has increased 150 percent, despite a recession-related stall in 2009 and an 11 percent drop in contracts traded last year post-MF Global.
CME says low interest rates and low volatility have dampened trading, but others point to doubts about the system.
“The black eye that MF Global gave the futures industry, combined with the lack of response from the federal government, has left the market with a lack of confidence,” says Jeff Carter, a former CME board member based in Chi-cago who doesn’t trade anymore. “It will take a long time to bring confidence back to public markets.”
Another example is Rohit Patel, an independent electronic trader based in Dallas who initially lost $100,000 in the MF Global collapse and says he’s doing only about a fifth as much trading as in the past. Although he recouped most of that money, he says the slow return of his capital and the forced liquidation of positions he held in several accounts at MF Global multiplied his real losses to as much as $2 million.
“I am still trading futures, but I’ve cut back a lot,” Mr. Patel says. “I just don’t have as much faith in the system or the regulators.”
As floor trading declined, CME’s caseload contracted by more than half to 162 in 2012 from 455 in 2008, with many of the recordkeeping and procedural violations that were commonplace on the trading floor rare in the electronic realm. There was no obvious corresponding rise in electronic trading violations.
Several people who serve on CME disciplinary committees say that’s because recordkeeping mistakes, or even fraud, are less likely to occur in an automated system. But others question whether CME and other regulators have tools sophisticated enough to police the high-speed electronic traders, most of which are so-called prop shops, using their own capital rather than trading on behalf of customers.
Eric Wolff, a former head of market regulation at CME who serves on NFA’s business conduct committee, says that part of the problem is an unequal distribution of brainpower.
“I suspect that there are forms of violations—although clearly less frequent—that are occurring that are more difficult to detect because of the relative anonymity of electronic trading, that only really powerful analytic software is ever going to find. It’s not so much about resources—it’s about where the rocket scientists are. The rocket scientists are developing trading algorithms for prop trading shops,” says Mr. Wolff, who also is an industry consultant. “They’re not developing surveillance software for regulators.”
CME says the percentage of electronic violation cases has increased and last year led to two-thirds of all its enforcement actions. But it would not provide specific numbers and says it came to that conclusion by excluding pit-based recordkeeping cases.
CFTC Commissioner Bart Chilton says there’s evidence electronic traders routinely execute “wash trades,” an illegal move to buy and sell a contract with the intent of boosting trading volume and manipulating the price.
“I think we all are behind the curve in doing the types of surveillance, monitoring and enforcement that we need to do in the fast-paced ‘cheetah’ trading world,” Mr. Chilton says. “It’s almost impossible to keep up with them—you certainly can’t do it in real time. I’m convinced that on a regular basis, we miss a lot of things that have the potential to be unlawful.”
A recent study of NFA’s response to Peregrine found that front-line regulators were often green and easily intimidated. At CME, they’re more reluctant to acknowledge structural weaknesses.
“We have worked very hard over the last couple of decades, I would say, in trying to stay ahead of the curve in the context of developing very sophisticated surveillance technology, and we did so with the mindset of having technology that evolves with the market,” Mr. Durkin says.
In the handful of recent CME cases against high-speed trading firms whose systems ran amok, CME slapped them with some of its biggest fines, underscoring their threat to the market.
“The risks have changed,” says Neal Wolkoff, who formerly led CME rival ELX Futures L.P., a smaller, New York-based exchange. “Rather than serious risk to individual customers, it’s rather much more to the market as a whole.”
Chicago-based Infinium Capital Management LLC paid $850,000 in 2011 to settle charges that on different occasions in 2009 and 2010 its systems went haywire, in one case spitting out thousands of errant orders. Infinium sought and received price adjustments on the orders.
“The problem with the automation is that it’s like the ‘I Love Lucy’ episode where something goes wrong on the conveyor belt in the factory. It’s not just one mistake,” says Dale Rosenthal, an assistant professor of finance at the University of Illinois at Chicago and a former derivatives trader at Long-Term Capital Management L.P. “That said, it’s very easy to reform that sort of thing because you have clear evidence.”
But CME didn’t always spot the snafus itself. Rather, like Infinium, the firms reported problems, sometimes in hopes of revising bad trades. (Adjusting or canceling trades is frowned upon as a form of revisionist history, changing the way the market responded at a particular point in time.)
Unlike CME, NFA’s caseload has fluctuated over the past five years. The 2009 number was up more than 50 percent over 2008, mainly because the organization was granted more enforcement authority over foreign exchange firms. The association had been campaigning for years to have more authority in that area and ardently pursued targets once it received the go-ahead, Mr. Roth says. Even so, the total caseload fell 23 percent from that peak in 2011 and 2012.
Any fluctuations in caseload during the most recent five years are less important than a roughly 20 percent increase in actions by the association compared with 2002-07, he says. “Our risk-profiling system prior to that wasn’t as sophisticated as it is now,” Mr. Roth says.
The manner in which the Peregrine fraud was discovered highlights how NFA’s enforcement tools had fallen behind the times. The criminal activity was spotted within 24 hours after the association deployed an electronic bank statement confirmation service, called Confirmation.com. The service has been in use at the top 10 U.S. banks since 2010 and at some other regulators even longer, says Brian Fox, founder and chief marketing officer of the service.
Once wrongdoing is alleged, the most serious cases go to the CFTC for civil court proceedings or to the Justice Department for criminal prosecution. That was the case with Peregrine CEO Russell Wasendorf (at right), 65, who is serving a 50-year sentence at a federal penitentiary in Terre Haute, Ind. Neither MF Global nor any of its executives have been charged with wrongdoing, although the firm remains under investigation by both the CFTC and the Justice Department.
CASELOAD DOUBLED
The CFTC says its annual caseload has nearly doubled, to 153 cases in 2012 from 85 in 2008. (Those figures include some cases outside the futures markets, such as Ponzi schemes.) “We have ramped up a lot,” says CFTC spokesman Steven Adamske, noting the agency’s enforcement staff has risen to 700 employees from 400 in the mid-2000s. Still, CFTC Chairman Gary Gensler said in congressional testimony in February that the agency was being forced to shelve some enforcement cases for lack of resources.
The feds have worried openly that CME has been slow to recognize the new order. In a 2010 review of enforcement procedures at the company’s Chicago Board of Trade and Chicago Mercantile Exchange and again in a 2011 review of CME’s Nymex, the agency expressed concern that CME’s compliance staff was being overtaken by rising trading volume and the increased number of products.
CME says it has increased its compliance budget to $40 million annually and has a total enforcement staff of about 200, with plans to add 11 positions this year.
Once CME regulators determine that punishment is warranted, they rely almost exclusively on fines to penalize rule-breakers. In each of the five years examined, more than 90 percent of the punishments assessed by CME were fines. Twelve cases resulted in fines of more than $200,000, including five against FCMs and two related to automated trading systems that went haywire. CME declines to say how much it collected in fines over the five-year period.
NFA also turned frequently to fines but was more likely than CME to bar wrongdoers permanently. NFA tended to deal more harshly with firms than individuals. A firmwide problem is a “serious rule violation,” but sometimes an individual just ends up at a “bad firm,” NFA’s Mr. Roth says.
NFA says it collected $7.1 million of the $7.4 million in fines it levied over the five-year period. If fines aren’t paid, members are barred.
SHORT ON INFORMATION
But the system is far from transparent, a major obstacle in assessing the regulators’ performance. For instance, it’s difficult to find out basic facts such as how many electronic trading firms are active on the futures exchanges.
Matt Simon, a senior analyst at Tabb Group, a financial markets research firm based in New York, estimates that high-speed traders are responsible for about half of futures trading volume. But he’s not sure because CME stopped sharing that information with him two years ago. Understanding where an order begins and ends is an important part of market transparency, Mr. Simon says.
CME won’t disclose the names of its high-speed market-making firms. “We consider that information to be proprietary customer information,” Mr. Durkin says.
Mr. Chilton of the CFTC says CME won’t disclose that information to him, either. He has urged requiring registration by the high-speed trading firms, but some commissioners oppose a mandate on firms that only trade for their own accounts and don’t use customer money.
CME also doesn’t disclose the names of people who sit on its disciplinary committees, though NFA does.
“We don’t want parties who may be appearing before a disciplinary panel to be in a possible position to influence those sitting on the panel,” Mr. Durkin says. If a case is moving forward to a hearing, then panelist names are disclosed to the parties, he adds—but not to the public.
And, as with any self-regulated organization, there are questions about conflicts of interest. CME, which is owned by shareholders, and NFA, which is funded and led by its 35,000 industry members, are focused keenly on expanding the futures market. Neither organization discloses publicly that a firm or individual has been charged with wrongdoing until a case has been resolved, sometimes years later.
Despite the recent scandals, CME has shown a reluctance to change even when questioned by its government overseer. Earlier this year, for example, the CFTC held a public meeting to discuss a proposal to review how CME and NFA examine firms like MF Global and Peregrine.
“Why do we need to have this done?” asked Ann Bagan, the head of CME’s clearinghouse audit department, posing what she said was a “fundamental question” for the gathering, given existing CFTC avenues for oversight.
CFTC Director Gary Barnett, who heads the agency’s division overseeing the swaps market, responded: “So, you’re OK with the status quo?”
After losing money with MF Global, managers Phil Farrell, left, and Howard Laube, at Elburn Cooperative Co.’s Maple Park facility, have taken precautions with their funds. Photo: Kendall Karmanian
Managers at Elburn Cooperative Co., a farmer-owned grain elevator operation that handles 30 million bushels of grain annually, say they have no choice but to keep hedging risk through the futures market despite losing money with MF Global. But they doubt the system can prevent another debacle, so they spread their funds among three FCMs and don’t leave excess cash in their accounts.
“Do we feel like enough changes have been made so that things like this won’t happen again? No, we don’t,” says Phil Farrell, an assistant manager at the Sycamore-based co-op. The response from CME’s leadership was particularly troubling, he says. “It really rubbed people the wrong way when they told people they didn’t do anything wrong.”
AN AUDITING ISSUE
Both CME and NFA have treated the MF Global and Peregrine scandals largely as an auditing problem. NFA commissioned a report by an outside consultant, who recommended that the organization revamp auditor training and hiring practices, update auditing procedures and better incorporate information from its own disciplinary reviews.
CME stepped up its reporting requirements for futures commission merchants, which are now “subject to more transparency and more accountability as it pertains to the maintenance and reporting of segregated assets,” Mr. Durkin says. Those include daily reports on the balances of customer funds, CEO sign-off on the transfer of more than 25 percent of total customer funds and more frequent spot-checks by CME staff.
Will that be enough?
John Roe doesn’t think so. He’s a former MF Global commodity trading customer who helped create the Chicago-based Commodity Customer Coalition to demand the return of customers’ money lost in the firm’s collapse. He’s also a newly elected NFA board member and wants the group to ban Jon Corzine (at right), former chairman and CEO of MF Global, from the futures industry.
“This is a kind of bureaucratic malaise,” he says. “If we’re not going to hold the big guys to the standards everybody else has to play along with, you’ve got to throw your hands up and walk away from the whole system. I want to make sure the system works.”
But, at least so far, the response from market regulators is to tweak the system rather than overhaul it.
]]>By Tom Braithwaite in New York and Neil Munshi in Chicago
A judge approved the liquidation plan of MF Global, cementing the eighth-largest US bankruptcy and paving the way for the collapsed brokerage’s assets to be distributed to creditors.
The ruling in a New York court came a day after the bankruptcy’s trustee found Jon Corzine, the former chief executive, had contributed to the 2011 collapse with a risky trading strategy and inadequate controls.
Debt-fuelled bets on European government debt, coupled with credit ratings downgrades and a troubled global economy precipitated MF Global’s failure in October 2011.
A fire sale of the company was scuttled when would-be acquirers discovered missing customer funds that at one point amounted to more than $1bn.
But Louis Freeh, the court-appointed trustee, said after the ruling: “I do firmly believe that the customers in the case will be made whole, as a result of a lot of good work.”
A separate trustee, who is overseeing the wind-down of the brokerage unit, has estimated the recovery by customers at at least 93 cents on the dollar.
One of the biggest hurdles to the liquidation was removed last month when JPMorgan Chase, lender to MF Global, reached a settlement.
Judge Martin Glenn overruled other objections, noting that creditors had “overwhelmingly” supported the plan, and approved the liquidation on Friday. MF Global had assets of $41bn.
John Roe, manager of BTR Trading Group, a Chicago-based futures firm, who heads a group advocating for former MF Global customers, said the court approval did not restore customer confidence destroyed by the brokerage’s collapse.
“The problems that are underlying here are still there,” he said.
Mr Roe, whose customers had around $20m with MF Global, has been an outspoken critic of Mr Corzine, and has pushed for him and other executives to be held legally accountable for MF’s bankruptcy.
James Koutoulas, who heads Typhon, a second Chicago-based futures firm, said he was pleased that his customers, who had $55m with MF Global, would be getting their money back. But he added of the trustee’s report’s conclusions about the company’s management: “quite frankly I don’t think [Mr] Freeh went far enough”.
A spokesman for Mr Corzine on Thursday disputed the report’s conclusions. He said: “There simply is no basis for the suggestion that Mr Corzine breached his fiduciary duties or was negligent.”
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