Merrill Lynch, Pierce, Fenner & Smith Incorporated agreed to pay a fine of US $2.5 million to resolve charges brought by the Commodity Futures Trading Commission that, from January through October 2010, the firm failed to diligently supervise responses to a CME Group Market Regulation (“CME 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. The CFTC also charged Merrill – a CFTC-registered futures commission merchant – with having inadequate procedures related to the preparation and maintenance of records related to block trades, and for failing to prepare and/or maintain records related to certain block trades, as required by Commission regulation, from at least January 2010 through June 2012.
Separately, BANA agreed to pay an additional fine of US $2.5 million to resolve an investigation brought by the US Attorney's Office for the Western District of North Carolina for engaging in impermissible pre-hedging activity in connection with block trades. According to a settlement agreed to by BANA, during the relevant time, on occasion, some BANA traders would secretly listen to telephone calls by other BANA traders with customers regarding block trades, and pre-hedge those transactions prior to the block trades being consummated At the time, pre-hedging of block trades was not permitted on CME Group exchanges until after a block trade was executed. (Click here for sample CME Group Market Regulation Advisory Notice regarding Rule 526 dated January 6, 2015; see Q/A 10.)
According to the CFTC, in response to various inquiries by CME Market Regulation whether certain BANA personnel traded futures on CME Group’s Globex electronic trading platform in advance of executing corresponding block trades, Merrill’s legal and compliance staff (“L&C Staff”) relied on BANA’s business operations support group (“the Support Group”) to assemble relevant information and to communicate with relevant BANA traders, as necessary. CME Market Regulation’s inquiries were conducted from February 2008 through December 2010.
In response, said the CFTC, the Support Group – which did not report to Merrill’s or BANA’s L&C Staff – provided Merrill’s L&C Staff an analysis of the relevant trading that omitted showing “that on a number of occasions, certain [BANA] Swaps Desk traders traded substantial volumes of futures contracts on Globex in the five minute window before the recorded execution time of a block trade in that same futures contract.” BANA’s Support Group knew this information but kept it from Merrill’s L&C Staff.
Moreover, claimed the CFTC, BANA’s traders did not admit to trading ahead during interviews conducted by CME Market Regulation staff during November 2010. Consistent with this testimony, outside counsel for Merrill also wrote to CME Market Regulation in December 2010 “in reliance on the traders’ representations” that BANA’s traders “did not have advance knowledge of a block trade such as to enable them to engage in any trading prior to the execution of the block.” BANA withdrew this letter in May 2013.
The CFTC charged that Merrill’s L&C Staff’s reliance on BANA’s Support Group without more closely monitoring its work contributed to the firm’s inability to detect the purported trading ahead before BANA’s traders provided misleading information to CME Market Regulation. The CFTC charged that Merrill’s L&C Staff’s “minimal oversight” over the Support Group and failure “to stay adequately informed” of the Support Group’s findings constituted a failure to supervise its employees and agents in violation of CFTC requirements (click here to access CFTC Regulation 166.3).
The CFTC also charged as a failure to supervise that, from at least January 2010 through October 2010, Merrill had “inadequate procedures” regarding, among other matters, who was responsible for the preparation and maintenance of records related to block trades and how employees should record the execution time of a block trade. The Commission additionally alleged that, from at least January 2010 through June 2012, Merrill did not always record a correct execution time in connection with block trades on relevant trade tickets. This, said the Commission, constituted a violation of the CFTC’s recordkeeping requirements. (Click here to access current CFTC Regulation 1.31 and here for CFTC Regulation 1.35; these regulations were amended earlier this year, but did not materially impact obligations of FCMs related to block trades.)
In addition to agreeing to pay a fine, Merrill consented to have audits conducted at certain prescribed intervals during the next five years regarding certain elements of its handling of block trades. Merrill did not admit or deny any findings or conclusions published by the CFTC in agreeing to its settlement. BANA also agreed to various undertakings to resolve the US Attorney's Office's investigation; it agreed to all facts in its settlement order.
Both the CBOT and CME brought disciplinary actions against Merrill during October 2013 for failure to supervise; making a verbal or material misstatement to it; and not preparing accurate records regarding, and timely reporting, block trades, as required (click here to access the relevant CBOT Notice of Disciplinary Action and here to access the relevant CME notice). The facts underlying the CME Group disciplinary actions appear materially the same as those behind the CFTC’s action. Merrill agreed to pay an aggregate fine of US $250,000 to settle the CME Group disciplinary actions.
Bank of America Corporation ("BoA") owns both Merrill and BANA, although it did not completely acquire Merrill until January 1, 2009, after the initiation of CME Market Regulation's inquiries regarding BANA's block trades. BoA originally announced its intention to purchase Merrill during September 2008.
Compliance Weeds: Prior to November 8, 2016, all persons trading on CME Group exchanges were prohibited from engaging in pre-hedging transactions after receiving a counterparty order for a futures block trade until after such block trade was executed. Now, pre-hedging/anticipatory hedging is permitted on CME Group as well as other exchanges under certain circumstances, except when an intermediary takes the opposite side of its own customer order. (Click here for background in the FIA PowerPoint presentation entitled “Exchange Amendments to Block Trade Pre-Hedging Rules" dated November 21, 2016 by CME Group, ICE Futures U.S. and NASDAQ Futures. Clickhere for further background in the article “Pre-Hedging by Principals Authorized in Block Trade Clarification Implemented by IFUS and Adopted by CME Group” in the October 30, 2016 edition of Bridging the Week.)
My View: Although BANA admitted to impermissibly pre-hedging block trades and agreed to material sanctions for that offense, an important fall-out of Merrill's CFTC settlement order is the suggestion that registrants have an affirmative obligation of some kind to ensure that information and analysis they obtain from accountholders is accurate prior to passing it along to regulators even when they have no notice that such information may be inaccurate.
Here, as best as can be surmised from the limited facts set forth in the “Commission’s Order Instituting Proceedings, Making Findings, and Imposing Remedial Sanctions,” Merrill, in connection with a CME Group investigation, relied on an affiliated company (BANA)’s staff to obtain information about BANA’s activities. This is not uncommon within group structures. Likewise, it is not uncommon for registrants to make requests to customers, including affiliated companies, for information requested by regulators and pass along the information to the regulators without substantively testing the accuracy of the production.
There is no suggestion in the settlement order that Merrill somehow directly or indirectly oversaw or was responsible for BANA's swaps desk. Indeed the settlement order makes clear that BANA's Support Group acted fully independently of Merrill's L&C Staff. Moreover BANA's settlement did not suggest any role in its improprieties by Merrill.
According to the CFTC, the bad fact here is that BANA’s personnel allegedly provided Merrill with misleading information, which Merrill’s L&C Staff, and apparently outside counsel for Merrill, relied on – although there was no suggestion they relied on the information in bad faith. As a result, charged the CFTC, Merrill did not detect its affiliate’s possible wrongful conduct and somehow contributed to BANA’s traders providing purportedly misleading testimony to CME Group’s Market Regulation staff during interviews. This, claimed the CFTC, constituted a “failure to supervise” by Merrill of its employees and agents.
The relevant CFTC rule requires Commission registrants effectively to diligently supervise the handling “by its partners, officers, employees and agents…of all commodity interest accounts… and all other activities [of such persons]… relating to its business as a Commission registrant.” However, it is not clear from the settlement precisely what and whom Merrill failed to supervise.
When an affiliate or a third-party customer provides information or analysis to a registrant in response to a regulatory inquiry, it’s not the registrant’s fault if the information is false – absent knowledge by the registrant, or information that arguably suggests that the registrant should have known of the falsehood. Moreover, when a third-party customer or even an affiliate produces information to a registrant for ultimate production to a regulator, the accountholder is acting as principal and the registrant is acting as agent, not the other way around. The Merrill settlement seems to have gotten common sense and relationships wrong: this is not a circumstance of failure to supervise by a registrant; this is a circumstance of an accountholder – as principal – not necessarily telling the truth. Merrill – as far as it seems from the settlement order – was acting solely as an agent in serving as a conduit for information from BANA to CME Market Regulation.
Moreover, it is not clear why the CFTC chose to include in the settlement order a reference to the letter by outside counsel to CME Market Regulation. Apparently, outside counsel may also have been misled by BANA, Merrill’s principal. However, it is unclear how the counsel’s actions contributed (if at all) to Merrill’s failure to supervise charge.
The CFTC can now rely on an express provision of law to prosecute persons that make any false or misleading statement of a misleading material fact to it provided "the person knew, or reasonably should have known, the statement to be false or misleading." (Click here to access Commodity Exchange Act Section 6(c)(2), 7 U.S.C. §9(2).) The CFTC contorts the scope of this law unfairly in this matter.
Going forward, it appears that, when investigating potential wrongdoing by an accountholder, registrants may continue to rely on the accountholder for information. However, registrants may now be expected by the CFTC under their duty of supervision to at least somehow independently assess the reliability of the information – particularly analyses performed by persons that may not be truly independent of a potential wrongdoer – even when a registrant has no reason to think the information may be false or misleading. This may not be practical and seems contrary to the spirit of CEA Section 6(c)(2). Registrants may be required to know their customers, but they cannot be guarantors of their credibility.
Note: This article was amended by 7:30 am on September 25 after initial publication to include information related to the US Attorney's Office investigation and BANA's settlement.