Overview
Law360, New York (December 14, 2015, 10:38 AM ET) -- The use of derivatives, including futures, options and swaps, is widely accepted as an effective means of managing price risk associated with the production, ownership and merchandising of a wide variety of commodities and financial instruments. With the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act and the completion of the bulk of the Title VII implementing regulations by the US Commodity Futures Trading Commission, which oversees the commodity derivatives markets in the US, the number of rules and regulations affecting firms using commodity derivatives products has dramatically increased. As a result, market participants in the commodity derivatives markets, whether acting as a commercial hedger, speculator, trading venue, intermediary or adviser, are now subject to a panoply of new and revised regulatory requirements, some of which may not be intuitive. Moreover, to address implementation issues, CFTC staff has issued a series of no-action letters that modify or suspend certain requirements. Now, the CFTC is beginning to assess traders’ compliance with the multitude of requirements. Market participants that have not conducted appropriate due diligence and taken necessary steps to comply with all of the rules and related no-action letters are exposed to potential enforcement action that may result in significant monetary and reputational penalties and remedial requirements.
Discussion
To implement the Dodd-Frank changes to commodity law, the CFTC has become quite aggressive in adopting new rules as well as amending existing requirements, covering virtually every aspect of its derivatives oversight regime. These include rules governing the operation of traditional futures markets (designated contract markets) and attendant reporting requirements, the creation of swap execution venues (swap execution facilities or SEFs), clearing and trading mandates for certain more standardized swaps, requirements for reporting swap transaction data to swap data repositories, the establishment of a regulatory and oversight regime with business conduct standards for swap dealers, as well as margin requirements for uncleared swaps and position limits for physical commodities.
The CFTC also has adopted rules related to the obligations of a new oversight official required to be in place at many regulated entities — the chief compliance officer, who assumes significant legal risks attendant to his or her duties. In addition, the CFTC has made use of its expanded enforcement authorities under Dodd-Frank to prosecute attempted manipulation and disruptive trading. Finally, the CFTC has renewed its focus on activity that affects the derivatives markets or prices thereon, even though such activity may not directly relate to derivatives market activity, as evidenced by the numerous enforcement actions dealing with reference prices used to settle futures contracts.” [1]
While the CFTC is to be commended for completing the vast majority of the rule-makings mandated by Dodd-Frank, the haste to complete these rules created uncertainty in many areas. After promulgation of the final rules, the agency found that many new requirements could not be complied with for a number of reasons, including that: the assumptions inherent in the rules conflicted with the actual state of the industry; the time frames imposed for compliance created undue costs and hardships; there were conflicts with other rules; or certain unintended consequences needed to be addressed.
To address these concerns and provide greater certainty to market participants, at least for a limited time, the CFTC staff issued an unprecedented number of no-action letters, guidance and interpretations covering a wide swath of the new regulations. While many no-actions have expired as the industry came into compliance with specific requirements, others have been extended, some several times, pending final resolution of thorny issues. The chairman and staff have indicated that, ultimately, the CFTC likely will propose modifications to its existing rules to permanently and formally address the matters covered by such no-action letters.
However, staffing constraints and other high-priority matters, such as granting permanent registration to temporarily registered entities and preparing new rules, such as margin for uncleared swaps, systems safeguards, position limits and automated trading, suggest that necessary revisions to the existing rules to address implementation issues and to correct problematic requirements may not be forthcoming soon. Accordingly, market participants should keep track of the status of the numerous no-action letters to ensure they remain in compliance with existing obligations while hoping that the issues covered in the no-action letters are addressed in the final rules.
The broad scope of the CFTC’s rule-makings and related no-action letters, along with its expanded authorities, means that most participants in the derivatives space are affected in some way and should be aware of their potential exposure to enforcement actions related to noncompliance with technical aspects of the rules. Accordingly, market participants should take stock of the potential impact of the applicable rules on their actions in the derivatives markets. The new regulations, combined with the myriad existing requirements and the CFTC’s focus on enforcement actions with substantial monetary penalties to remedy wrongdoing, presents potentially greater risks for market participants and requires more intensive focus on compliance with the rules and policies.
Change in Compliance
The CFTC historically has used its compliance oversight programs to assist exchanges and traders coming into compliance with applicable requirements. This was accomplished through routine examinations of registered entities and by staff working with market participants to explain and discuss issues in order to help bring them into compliance with registration or reporting obligations and trading requirements. In recent years, however, the CFTC has become more aggressive in utilizing its enforcement powers to pursue market participants that may have failed to comply with the vast array of requirements, including long-standing rules as well as new requirements resulting from the Dodd-Frank reforms. This “gotcha” mentality signifies a new policy orientation by the CFTC and may be the result of inadequate staffing to engage in dialogue with the many market participants that now find themselves subject to CFTC rules and policies.
The CFTC announcements warning market participants about their obligations signal the agency’s focus on enforcement actions. For example, the agency’s enforcement director, Aitan Goelman, stated that “[t]he CFTC cannot carry out its vital mission of protecting market participants and ensuring market integrity without correct and complete reporting by registrants, including designated contract markets.”[2] In connection with the CFTC’s new ownership and control reporting rules, the staff has specifically instructed market participants to comply with the new rules.[3] The CFTC chairman recently emphasized the CFTC’s focus on accurate and complete reporting by stating that “[f]or those industry participants who do not make timely, complete and accurate reporting, we will not hesitate to carry out enforcement actions. We have done so already. Recently, we fined a major global bank $2.5 million dollars for repeated failures to comply with swap reporting obligations, including failing to report swaps and failing to correct errors in its reporting. And since the beginning of 2014, we have brought actions against six other institutions, including other major banks and an exchange, for various types of reporting violations. We will continue to promote compliance in recordkeeping and reporting — and hold those who are not in compliance accountable.”[4]
The CFTC has not only warned market participants about the consequences of noncompliance with regulatory requirements but has increased its activity in the enforcement area, instituting numerous actions covering a wide array of infractions. In that regard, for the five years after the passage of Dodd-Frank (2011 to 2015), the number of new enforcement actions has averaged 84 per year compared to only 43 for the five-year period prior to the adoption of Dodd-Frank. In fiscal year 2015, the CFTC filed 69 enforcement cases, receiving a record $3.14 billion in civil monetary penalties.[5] Including matters related to manipulation, trade practice abuses and spoofing, the CFTC’s enforcement division has aggressively taken action against market participants for a variety of violations, including commodity pool fraud, violations of position limits and related reporting requirements, bitcoin-related registration and trading issues, futures and swaps data reporting, and abuses related to the setting of Libor and foreign exchange benchmarks. The CFTC has initiated enforcement actions against market participants for violations that historically were treated by compliance staff working with traders to address potential issues. The consequences of this stepped-up enforcement activity can be steep, resulting in large penalties for seemingly minor infractions.[6]
The increased focus on enforcement is also evidenced in the CFTC’s stated priorities, as illustrated in its budget documents. In that regard, for fiscal year 2016, the CFTC requested $322 million and 895 full time equivalents (FTEs), representing an increase of $72 million and 149 FTEs over the FY 2015 enacted level.[7] Of the 149 additional staff requested, the CFTC planned to allocate 48 staff to enforcement, nearly one-third of the increase. This compares to the requested increase of only $1 million and three FTEs over the FY 2015 level for registration and compliance oversight activities.
As it noted in its budget request, limited funding for registration and compliance prevents the CFTC from fulfilling its mission in a timely and effective manner, and can create regulatory uncertainty, poor compliance and risk management by registrants as well as higher legal and compliance costs for registrants. This uncertainty and the enhanced potential for noncompliance combined with the CFTC staff’s diminished ability to work with market participants to address potential issues and the vast increase in regulatory requirements substantially increases the risk to market participants of violations, whether through inadequate notice of new rule obligations, misunderstandings as to how rules are to be applied, lack of attention to all of the details inherent in a rule-making, or otherwise.
Conclusion
It is likely only a matter of time before the CFTC, through additional warning statements and enforcement action, addresses the numerous mandates and compliance requirements faced by market participants related to the new swap rules, as the agency would have determined that enough time has passed for the industry to have come into compliance. Compliance risks have grown, not only due to the broad scope of new swap regulations on top of existing and expanded futures requirements, but also because the cash-strapped CFTC has come to rely more on enforcement actions to deal with violations rather than working with participants to address issues. Accordingly, it is imperative that market participants know their obligations and take appropriate steps to be in full compliance with the greatly expanded body of regulatory requirements. Prudent business practice requires vigilance about all legal and regulatory responsibilities and taking appropriate proactive steps to ensure compliance with the myriad rules and requirements before becoming the subject of a CFTC enforcement action. Failure to do so can result in unfortunate encounters with enforcement officials, financial penalties and significant reputational harm.
—By Michael V. Dunn and Richard Shilts, Steptoe & Johnson LLP
Michael Dunn is a senior policy adviser in Steptoe & Johnson's Washington, DC, office. He is a former acting chairman of the Commodity Futures Trading Commission and has held seven presidentially appointed positions involving oversight of federal regulation and policy, including commissioner of the CFTC.
Richard Shilts, also a senior policy adviser in Steptoe & Johnson's Washington office, spent four decades at the CFTC, including as the director of the Division of Market Oversight, a position he held for nine years and in which he played a significant role in the implementation of Dodd-Frank.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
[1] In this regard, the CFTC has imposed penalties of over $4.1 billion related to abuses of global financial benchmarks. See, e.g., CFTC Press Release, Deutsche Bank to Pay $800 Million Penalty to Settle CFTC Charges of Manipulation, Attempted Manipulation, and False Reporting of Libor and Euribor, available at http://www.cftc.gov/PressRoom/PressReleases/pr7159-15.
[2] See CFTC Press Release, CFTC Orders ICE Futures US, Inc. to Pay a $3 Million Civil Monetary Penalty for Recurring Data Reporting Violations, Mar. 16, 2015, available at http://www.cftc.gov/PressRoom/PressReleases/pr7136-15.
[3] CFTC Staff Advisory No. 15-14, Mar. 23, 2015, available at http://www.cftc.gov/idc/groups/public/@lrlettergeneral/documents/letter/15-14.pdf.
[4] See Keynote Remarks of Chairman Timothy Massad before the Futures Industry Association Futures and Options Expo, November 4, 2015, available at http://www.cftc.gov/PressRoom/SpeechesTestimony/opamassad-33.
[5] See CFTC Release PR7274-15, dated November 5, 2015.
[6] For example, the CFTC entered into a settlement with Libero Commodities SA, a small agricultural commodity-trading company in Switzerland using US futures to manage risk, which had inadvertently failed to file form 304 reports. Upon discovery of the applicable requirements, the firm promptly and voluntarily self-reported the deficiency and made all of the required filings to the CFTC. The $480, 000 civil monetary penalty imposed by the CFTC combined with any legal fees to address this matter seem to represent a significant penalty considering the nature of the violation and the firm’s willingness to self-report and promptly come into compliance. Such penalties, especially for small and start-up companies, can greatly affect whether the enterprise can remain profitable.
[7] See CFTC Budget Estimate for FY 2016 (Feb. 2, 2015), available at http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/cftcbudget2016.pdf.
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