Gary DeWaal and Associates LLC

Gary DeWaal's Bridging the Week: October 7 to 11 and 14, 2013

Valuable Lessons Learned    Bridging the Week    My View   
Published Date: October 14, 2013

The CFTC remained shut this past week, and as a result there was no news emanating from that agency. However, what was surprising was that there also was no significant news emanating from any of the principal international regulators or exchanges elsewhere either, although two exchanges announced interesting developments:

(Last week AlphaMetrix, among other things the purveyor of data aggregation services to the National Futures Association and the Chicago Mercantile Exchange that help them track customer funds held by futures commission merchants, reported that it had experienced financial problems. Among other things, as reported in a letter from AlphaMetrix to its customers dated October 10, this caused an affiliated commodity pool operator not to have "...paid management and incentive fees that were earned and owed to third party managers [although the CPO] has withdrawn those fees for payments from various pools." In addition, says the letter, "...the CPO has delayed fee rebates owed to certain of its third party money managers and participants, which should have been reinvested into various pools but were not. The fact that these rebates were not reinvested may have an impact on the pools' net asset values." The media has reported that subsequently, AlphaMetrix issued a further statement reminding its fund investors that "[i]vestor assets remain under the operation of the [AlphaMetrix CPO], which are on deposit with futures commission merchants and cash custodians." At this point, there are no legal or regulatory developments regarding this matter, so it is beyond the scope of this article. However, we will be following this matter closely.)

In light of the dearth of current regulatory news, three interesting older matters not previously covered on this website are worth reviewing at this time. These are that:

Video Overview:

Article Overview:

Single Securities Regulator Proposed for Canada

On September 19, the Ministers of Finance of Canada, as well as of two Canadian provinces, British Columbia and Ontario, agreed to establish a single country-wide capital markets regulator and invited all other Canadian provinces and territories to participate in the proposed new system.

Proposed to be headquartered in Toronto, the new as of yet unnamed regulator would have as objectives to (1) provide better protection for investors; (2) enhance Canada's financial services sector; (3) support efficient capital markets; and (4) manage systemic risk. The new regulator would be responsible for policy development and regulation drafting, regulatory operations, enforcement, and there would be a separate and independent adjudicative tribunal.

Under the proposal, there would be both provincial and national regulation of capital markets. Each participating Canadian province and territory would adopt a single uniform Act to address all of the areas of securities legislation the Canadian provinces currently address. A Federal Act would address criminal matters and matters related to systemic risk. The new regulator would administer both the provincial and federal Acts, and have offices in each province, and would have a fee structure to support its self-funding.

Currently, Canada is the only major industrialized country without a national securities regulator. Securities regulation is administered separately by each province and territory.

The proposed national system is expected to be instituted by July 1, 2015.

In 2011, the Supreme Court of Canada struck down a similar effort to create a single Canadian securities regulator on the grounds that it did not fall within the power of the national government to regulate trade and commerce. However, in that decision, the Court held open the possibility of the national government adopting a "cooperative approach that permits a scheme recognizing the essentially provincial nature of securities regulation while allowing Parliament to deal with genuinely national concerns…"

FCMs Not Responsible Forever for a Former Guaranteed Introducing Broker

In a legal decision involving the defunct Peregrine Financial Group, the United States Court of Appeals for the Seventh Circuit (covering Illinois, Indiana and Wisconsin) ruled during July that futures commission merchants are not liable for the illegal acts of formerly guaranteed introducing brokers that occurred after the guarantee between the FCM and IB was terminated

In this case, Prestwick Capital Management Ltd. and two affiliates (collectively, "Prestwick"), Canadian investment companies, originally sued Acuvest Inc., a Commodity Futures Trading Commission registered IB, and two of its principals for fraud, and PFG as the guarantor of Acuvest. The lower court hearing this matter, dismissed PFG from this matter, and Prestwick appealed.

Under rules of the CFTC, there are two types of IBs: one that meets a minimum net capital requirement of at least US $45,000, and another – a so called guaranteed IB – that is not required to meet any minimum net capital requirement, but instead has all its obligations guaranteed by an FCM to which it must exclusively introduce all its customers' accounts. An FCM is jointly and severally liable for violations of law or rules by an IB it guarantees.

Here Prestwick opened its accounts at PFG through Acuvest at a time that Acuvest was guaranteed by PFG. However, the alleged fraud occurred after PFG terminated its guarantee of Acuvest but prior to a time PFG guaranteed Acuvest a second time. The termination was effectuated by an appropriate notice from PFG to the National Futures Association as well as to Acuvest.

Prestwick claimed on appeal that PFG forever was liable for Acuvest's fraud related to accounts opened at PFG during the time of its guarantee of Acuvest. Failing that, Prestwick claimed that PFG never effectively ended its guarantee of Acuvest. The Court of Appeals rejected both arguments. According to the Court,

"Prestwick apparently believes that CFTC regulations – and guarantee agreements...—have different meanings based on brokers' actions after such agreements are terminated. It is unclear… why Prestwick would consider this fair or sound policy. To the extent that good public policy means that someone must be liable in situations like these, we fail to see why the guarantor who properly terminated its relationship with a broker must be the party left ‘holding the bag'."

Valuable Lessons Learned:
Court decisions regarding the liability of FCMs for IBs have been muddled since a 1987 decision of the CFTC in Reed v. Sage Group, that held an FCM liable for the acts of an independent IB, mostly because the FCM performed routine activities as an executing and clearing firm on behalf of the IB. Although the CFTC argued that it was only the extraordinary activities performed by the FCM in Reed that caused the IB to be regarded as the FCM's agent looking at the totality of the circumstances, in fact many of these activities were not extraordinary at all (e.g. IB customers opened accounts using FCM documents; FCM distributed research to IB; IB introduced most of its accounts to FCM). The Prestwick decision perhaps begins the judicial journey back to respecting applicable law regarding the difference in liability standards between a guaranteed IB and a non-guaranteed IB. However, FCMs should continue to ensure that their IB agreements and relationships are truly bilateral and do not impose unilateral obligations on the IB that would not be typical in an arms length relationship. Be wary of including obligations in an IB agreement that require the IB to comply with general FCM policies and procedures, to submit to FCM inspections, or to provide access to proprietary books and records.

Sentinel Lender Must Face Further Proceedings to Determine Whether Disputed Funds Held Under a Lien are Owed to Customers

The United States Court of Appeals for the Seventh Circuit ruled during August that further proceedings must be held at the district court level to determine whether Bank of New York (now BNY Mellon) appropriately protected itself by asserting a lien on assets of Sentinel Management Group, an investment manager that filed bankruptcy in 2007. Alternatively, was BONY aware that Sentinel inappropriately was using protected customer assets to secure its lien, in which case it must return US $312 Million, the value of collateral it held.

Sentinel's customers were often futures commission merchants seeking a "decent return while maintaining the liquidity FCMs need[ed]," noted the Court. Sentinel itself was registered with the CFTC as an FCM and was required to comply with the CFTC's customer funds' protection requirements like all other FCMs in connection with its handling of customer assets.

Prior to filing for bankruptcy, Sentinel maintained a credit line at BONY for its proprietary activities, and granted a lien to BONY on certain of its assets for this. However, at the time of bankruptcy, Sentinel commingled customer and non-customer assets contrary to law.

The question addressed by the Appellate Court was whether the lower court committed error when it dismissed the Trustee's claim that BONY improperly used Sentinel's customer assets to secure its lien, because of knowledge BONY had "…and, as a result, acted inequitably and unlawfully." The lower court had held that BONY did not have the requisite knowledge of wrong doing, but the Court of Appeals reversed this decision and remanded this case back to the lower court for another trial. This was because the Court of Appeals found "significant inconsistencies in both the factual and legal findings" in the lower court's opinion that left it unclear whether BONY knew or not of Sentinel's misconduct.

And briefly:

My View: Remember two years ago when the CFTC amended its rule regarding permitted investments of customer funds? Among other things, the CFTC prohibited investment of customers funds in non-US sovereign debt, even up to the amount of client funds held in the relevant non-US currency because of client deposits and trading. The rationale was that non-US sovereign debt was not as secure as US-sovereign debt. This was an unjustified decision then, and looks like an even more unjustified decision now: is the debt of any country within the G-20 other than the US currently in danger of default?

For more information, see:

CME Pre-Execution Discussions for Grains and Oilseeds Options Overnight (see October 7 entry: "Pre-Execution Discussions"):
HKFE Clearing Corporation Treasury Bills Haircut:
In re: Sentinel Management Group:
Prestwick Capital Management Ltd v Peregrine Financial Group Inc:
Proposed Canada Securities Regulator
Canada Agreement in Principle to Establish a Cooperative Capital Markets Regulator:
2011 Canada Supreme Court decision regarding the Proposed Establishment of a National Securities Regulator:

The information contained in this article is not legal advice. For legal advice, please consult with your attorney. The information in this article is derived from sources believed to be reliable as of October 12, 2013, but no representation or warranty is made regarding the accuracy of any statement. To ensure compliance with requirements imposed by U.S. Treasury Regulations, Gary DeWaal and Associates LLC informs you that any U.S. tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Gary DeWaal and Associates may represent one or more entities mentioned in this article.


© 2024 Gary DeWaal and Associates LLC | 1 (212) 382-4615 | 1180 Avenue of the Americas, Suite 809, New York, NY 10036