United States: Record Spoofing Settlement Provides Guidance For Traders

The U.S. Department of Justice and the Commodity Futures Trading Commission on Nov. 6 separately entered into related and coordinated resolutions of criminal and civil charges with Tower Research Capital LLC, a proprietary trading firm. While this case is significant because it resulted in the largest total monetary sanction ever assessed in a case based on alleged spoofing in futures markets¹ — $67.4 million — derivatives traders and their counsel should note several important takeaways from these dispositions.

Specifically, the Tower settlements provide insight into the increasing coordination between the DOJ and the CFTC in spoofing investigations, the framing of spoofing violations, cooperation credit, and the elements of adequate corporate compliance programs.

The CFTC settlement order also identifies new legal issues for market participants who may need a CFTC-issued waiver from the U.S. Securities and Exchange Commission's private securities offerings prohibition for bad actors under SEC Rule 506(d).

Spoofing is a discrete offense under Section 4c(a)(5)(C) of the Commodity Exchange Act² for bidding or offering on a CFTC-registered exchange or trading facility with the specific intent to cancel the bid or offer before execution.

The alleged wrongdoing involved thousands of instances of spoofing by three former Tower traders in E-mini futures contracts on the Chicago Mercantile Exchange and Chicago Board of Trade during the period between March 2012 and December 2013.³

While spoofing is at the heart of the alleged unlawful activity, it more importantly served in combination with otherwise lawful and genuine bids and offers as the foundation for the DOJ's and CFTC's more serious charges of criminal and civil fraud.

Pursuant to the DOJ's resolution, Tower entered into a deferred prosecution agreement, or DPA, with the fraud section of the DOJ's Criminal Division and the U.S. Attorney's Office for the Southern District of Texas, and consented to the filing of a criminal information in the federal district court in Houston that charged one count of criminal commodities fraud under Title 18 of U.S. Code Section 1348(1).⁴

That provision makes it a felony, as relevant here, to knowingly execute, or attempt to execute, "a scheme or artifice to defraud any person in connection with any commodity for future delivery."

The DPA included Tower's admission to a statement of facts attached to the DPA and to the allegations in the criminal information. Pursuant to the DPA, if Tower complies with its terms over the next three years, the DOJ will seek dismissal with prejudice of the information and will not file charges in the future against Tower based on the conduct described in the DPA.

The CFTC's order charged civil violations of both the CEA's anti-spoofing prohibition and the anti-manipulation and antifraud provisions in CEA Section 6c(1)⁵ and CFTC Rules 180.1(1) and (3) thereunder.⁶ The order also imposed a cease and desist order against future violations and, somewhat controversially, effectively waived Tower's disqualification from making private securities offerings on the basis of the so-called "bad actor" provisions of SEC Rule 506(d)(l) of Regulation D⁷ as a consequence of the findings in the CFTC order.

This aspect of the order spawned a dissent from CFTC Commissioner Dan Berkovitz⁸ and a separate expression of "extreme reservation" from Commissioner Rostin Behnam⁹, who voted in favor of the settlement. The order also sets forth Tower's agreement to "undertakings" that commit it to, among other things, cooperate for a period of five years in any current or future CFTC investigation or action related thereto, and comply with the obligations relating to its corporate compliance program and reporting requirements set forth in the DPA.¹⁰

DOJ and CFTC Coordination

The DOJ's involvement began with a CFTC referral to it of Tower's activities for criminal investigation. The identical and reciprocal structure of the DOJ's and the CFTC's monetary sanctions reflects the deep coordination between them in the ultimate disposition of their investigations. As discussed below, the reliance on the application of the federal sentencing guidelines, rather than the CFTC's enforcement policies, to determine the monetary credit Tower received for its cooperation and remedial measures is emblematic that the criminal disposition is naturally the leading concern in reaching a global settlement.

The Government's Theory of Fraud

The Tower case seems to be an example of how the lawfulness or unlawfulness of any derivatives market order can depend on the context in which it is entered and executed. That an order that complies with all the market rules might nonetheless be considered unlawful when used in a way that contravenes market integrity.

The DOJ and CFTC theory of fraud is not based on allegations of spoof orders alone. Rather, they allege that the fraud arose from Tower's use of spoof orders in combination with entering permissible and otherwise legitimate "iceberg" orders, and that the alleged scheme was designed to trick other market participants into executing against the iceberg orders, while Tower's traders cancelled the spoof orders before they could be filled.

One takeaway from the government's theory of fraud is that market participants using iceberg orders should be mindful of how they might be perceived to act with one's other open market orders to avoid misperceptions of creating false appearances of supply and demand in the order book.

Iceberg orders are orders that permit other market participants to see only a portion of the full size of the orders at any given time. Nothing signifies to the market that an order is an iceberg order, such that other market participants have no notice that an additional volume of orders lies beneath what is visible to them in the exchange's order book. In short, they hide the full supply and demand of resting bids and offers in an order book.

The government contends that Tower's traders intended to and did use the combination of illegitimate spoof orders and legitimate iceberg orders to create a false appearance of an imbalance of offers to sell — supply — and bids to buy — demand — in the exchanges' order books.

Footnotes

1. The monetary sanctions are apportioned among approximately $32.5 million in payment for restitution of victim's losses, $10.5 million for disgorgement of ill-gotten gains, and $24.4 million for criminal/civil penalties.

2. 7 U.S.C. § 6c(a)(5)(C).

3. The specific contracts included the E-mini S&P 500 and E-mini NASDAQ 100 futures contracts traded on the CME and the E-mini Dow ($5) futures contract traded on the CBOT. In 2018, two of the traders entered guilty pleas for conspiracy to engage in wire fraud, commodities fraud and spoofing, and the third has been indicted and the case remains pending.

4. U.S. v. Tower Research Capital LLC, Criminal No. 19-cr-819 (S.D. Tex.). Available at https://www.justice.gov/opa/press-release/file/1215851/download.

5. 7 U.S.C. § 9(1).

6. 17 C.F.R. § 180.1(1) and (3). In the Matter of Tower Research Capital LLC, CFTC Doc. No. 20-06 (Nov. 6, 2019).

7. 17 C.F.R. § 230.506(d)(l) (2019).

8. Dissenting Statement of Commissioner Dan M. Berkovitz, In re Tower Research Capital LLC: Waiver of SEC "Bad Actor" Disqualifications, available at https://www.cftc.gov/PressRoom/SpeechesTestimony/berkovitzstatement110719.

9. Statement of Commissioner Rostin Behnam Regarding Tower Research Capital LLC, available at https://www.cftc.gov/PressRoom/SpeechesTestimony/behnamstatement110719.

10. Tower entered into the settlement with the CFTC without admitting or denying the CFTC's findings and conclusions in its settlement order, except to the extent that Tower admitted any finding in any related action against Tower by, or any agreement with, DOJ or any other governmental agency or office. The CFTC order also provides that Tower does not consent to the use of Tower's Offer of Settlement or the CFTC's Order, or the findings and conclusions in the Order, "by any other party in any other proceeding." This might prove relevant to Tower with respect to a pending putative class action against it in the U.S. District Court for the Northern District of Illinois concerning the same trading activity. Boutchard v. Gandhi, et al., No. 18-cv-7041 (N.D. Ill.).

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Originally Published by: Law360

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