The Commodity Futures Trading Commission brought and settled enforcement actions against two commodity pool operators for failure to supervise.

In one action, the CFTC charged Tillage Commodities, LLC, a CFTC-registered CPO, with failure to supervise for not monitoring and detecting unauthorized wire transfers processed by the administrator of a fund it operated, Tillage Commodities Fund, L.P. In the second action, the CFTC alleged that Logista Advisors LLC, a CFTC-registered CPO and commodity trading advisor, failed to detect one of its employee’s alleged spoofing-type trading of crude oil futures on a non-US exchange, and then failed to provide to its futures commission merchant and the non-US exchange accurate explanations of the trading in response to the non-US exchange’s inquiry.

To resolve these enforcement actions, Tillage agreed to pay a fine of US $150,000 while Logista consented to remit a fine of US $250,000.

The CFTC claimed that, from at least March 3 through 24, 2016, Tillage’s fund administrator received seven fake requests to transfer funds from the pool’s bank account to two Hong Kong-based companies. The Commission claimed these requests were made by an unauthorized person who “spoofed” the email account of Tillage’s managing member and designed transfer requests that “in some respects” emulated the CPO’s “typical” requests. In response, the administrator transferred funds to the Hong Kong companies on five occasions during the relevant time, ranging in amounts from US $200,000 to US $3 million.

The CFTC said that Tillage only learned of the ongoing fraud on March 24 after the fund’s administrator alerted it –after 21 days and the five unauthorized transfers. This was because, claimed the CFTC, during the relevant time, Tillage had no procedures requiring its monitoring of the administrator’s transfers from the fund’s bank account. During this time, noted the CFTC, Tillage only once reviewed the pool’s bank account balance and never reviewed activity in the account although it was available on the bank’s website. As a result, alleged the CFTC, US $5.9 million (or 64 percent) of the pool’s total capital was lost. This failure to monitor its agent’s activities and to develop and put in place policies and procedures to detect potential unauthorized or fraudulent activity involving its pool’s bank account, constituted a failure to supervise under CFTC rules, charged the Commission (click here to access CFTC Rule 166.3).

However, in a lawsuit filed in a New York State court by the Tillage fund against its administrator, SS&C Technologies, Inc., the fund claimed that SS&C's gross and willful misconduct, as well as bad faith in the performance of its contractual services related to the spoofed wire transfer requests, caused the pool's losses. As alleged in Tillage fund's complaint in its lawsuit filed in September 2016, SS&C failed to utilize minimum industry-standard cybersecurity protections in handling the fake wire transfer requests, let alone the heightened protections it promised to apply, including a filtering tool on all incoming email communications. Among other deficiencies, the Tillage fund claimed that SS&C accepted wire transfer requests from an incorrect email address (@tilllagecapital.com) instead of its correct address (@tillagecapital.com – the fake email address had 3l's not 2l's). Moreover, the fake wire transfer requests, said the fund, were "wholly inconsistent" with its prior email communications in that they included "awkward syntax and grammatical errors;" were for amounts far in excess of previously requested amounts; and were for transfers to destinations (Hong Kong) never before requested. Moreover, alleged the fund, SS&C did not acknowledge receipt of the fake wire transfer requests by using a "Send Secure button" as promised, "which would have immediately routed SS&C's response to the fund's proper email domain – thus alerting Tillage of the fraud."

SS&C filed a third party complaint against Tillage and Tillage Commodities Management, LLC in June 2017 claiming that the third-party defendants' failure to oversee the fund's bank account, not its own conduct, caused the fund's losses. SS&C previously also filed a motion to dismiss the fund's lawsuit against it. The court declined to dismiss the Tillage fund's allegations of breach of contract and implied covenant of good faith and fair dealing against SS&C, but dismissed other claims it posited. SS&C denied any liability to the fund.

In settling its enforcement action against Tillage, the CFTC acknowledged that the majority of the funds in the pool had been held by the CPO’s managing member, and that following discovery of the fraud, all pool participants were offered an opportunity to redeem their fund interests in full or part at the value prior to the fraud. Most pool participants received a full redemption.

Separately, Logista was charged with failure to supervise when, from September 2013 through October 2014, one of its employees engaged in alleged spoofing-type trading involving crude oil futures on a non-US exchange, and the firm did not detect this activity. Moreover, said the CFTC, after the non-US exchange contacted Logista’s FCM regarding specific trading on August 22, 2014, the relevant trader’s supervisor “did not examine Logista’s [trading] for the date in question, even after the exchange provided specific examples of the spoofing conduct, and did not ask the trader for an explanation of the conduct.” As a result, charged the CFTC, Logista provided its FCM and the non-US exchange with purportedly inaccurate explanations for the trading and continued not to detect the trader’s alleged spoofing trading.

Compliance Weeds: Two weeks ago, Merrill Lynch, Pierce, Fenner & Smith Incorporated agreed to pay a fine of US $2.5 million to resolve charges brought by the CFTC that, from January through October 2010, the firm failed to diligently supervise responses to a CME Group Market Regulation investigation related to block trades executed by its affiliate, Bank of America, N.A. (“BANA”) on the Chicago Mercantile Exchange and the Chicago Board of Trade. However, from the facts included in the CFTC’s settlement order with Merrill as well as BANA’s separate settlement with the US Attorney’s Office for the Western District of North Carolina, it is unclear what Merrill might have failed to supervise. From all referenced facts, it appears that Merrill was misled by BANA regarding BANA’s handling of the relevant block trades and had no reason to believe it was being misled. As a result, it is hard to comprehend the legal basis for the CFTC’s failure to supervise claim against Merrill unless the CFTC is proposing some new obligation by registrants to verify information provided to them by third parties that they do not believe to be false or have reason to suspect might be false. (Click here for background in the article, "FCM Agrees to Pay US $2.5 Million CFTC Fine for Relying on Affiliate’s Purportedly Misleading Analysis of Block Trades for a CME Group Investigation" in the September 24, 2017 edition of Bridging the Week.)

The legal basis for the CFTC’s failure to supervise against Tillage and Logista appears to rest on more traditional ground, although in each action, the respondent declined to admit any findings or conclusions.

In the Tillage case, the CFTC did not charge the CPO for the actions of its fund administrator in responding to the fake transfer instructions. It solely charged the firm for not monitoring bank accounts regularly to increase its likelihood of detecting possible fraudulent transfers and for not having policies and procedures to engage in such monitoring. CPOs should consider double-checking what their policies and procedures say regarding such monitoring, as well as what their ongoing practices are.

In the Logista case, the alleged spoofing occurred on a non-US exchange. However, the CFTC did not charge the CPO with spoofing. The Commission charged the CPO with not detecting its employee’s purported spoofing even after it was alerted of the potential issue following the non-US exchange’s detection of the possible wrongful trading activity, and with not conducting a reasonable review of the trading (including talking to its trader) prior to responding to the non-US exchange’s request for an explanation of the trading. Logista, said the CFTC, also did not have policies and procedures to detect spoofing, and did not itself detect the alleged spoofing.

This matter echoes the CFTC’s enforcement action against Advantage Future LLC during September 2016, where the firm and two of its senior officers also settled charges related to the firm’s handling of the trading account of one customer in response to three exchanges’ warnings and for the firm’s alleged failure to follow its own risk management policies. (Click here for background in the article, “FCM, CEO and CRO Sued by CFTC for Failure to Supervise and Risk-Related Offenses” in the September 25, 2016 edition of Bridging the Week.)

CPOs and other registrants should consider reviewing their policies and procedures to assess how effectively they address the ongoing monitoring of proprietary trading, as well as how they address the handling of all regulatory inquiries.

My View: Although the CFTC's enforcement actions against Tillage and Logista may have rested on stronger legal grounds than the CFTC's most recent enforcement action for failure to supervise against Merrill, it is not clear what public purpose was served by the legal action against Tillage.

Tillage sustained substantial losses because of the wire transfer fraud perpetuated by a third party – losses that for public customers were covered by its managing member. Moreover, at least as alleged in its private lawsuit against SS&C, Tillage's fund's administrator may have played a material role in allowing the fraud to occur by not following contracted-for processes that, if followed, might have alerted Tillage to the fraud earlier; SS&C has denied these claims. Undeniably, however, Tillage was a victim here, and although it may have failed to detect the fraud earlier itself, bringing an enforcement action against Tillage and requiring the firm to pay a fine appears harsh under all the circumstances.