Zero Tolerance for FCM Customer Fund Violations: CFTC Notches Another Segregated Accounts Action on Technicalities
By Eric Hess, Hess Legal Counsel
Originally published on TABB Forum
CFTC enforcement has been extremely focused on segregated accounts and secured funds issues … and not just those that involve fraud. There have now been 11 actions related to segregated accounts issues over the past two years that involve back-office operational or clerical errors.
In the continuing wake of the Peregrine Financial and MF Global sagas, it is no surprise that CFTC enforcement has been extremely focused on segregated accounts and secured funds issues … and not just those that involve the litany of fraud, Ponzi, misappropriation and unregistered conduct that you typically see in CFTC enforcement cases. There have now been 11 actions (listed and linked to at the end of this post) related to segregated accounts issues (and increasingly secured funds issues) over the past two years that do not involve fraud or reckless conduct, but rather back-office operational, or just general, clerical errors.
The publication last month of CFTC’s order against Morgan Stanley Smith Barney’s (MSSB) Futures Commission Merchant (FCM) (the “Order”) is certainly no exception. Although MSSB’s FCM is one of the top five or six FCMs in terms of aggregate segregated account balances (as of January 2014), this is a case where MSSB acted swiftly once it became aware of its segregated account issues by not only immediately self-reporting (possibly taking heed of the Vision Financial, Mizuho and Cantor Fitzgerald [listed below] segregated funds actions where the delay to timely self-report was a cited violation) once it became aware of a one-day customer segregated account shortfall due purely to an administrative error. Further, MSSB retained an outside consultant, KPMG, to conduct a review of its segregated accounts and secure funds policies and procedures.
While the action, and perhaps the retention of KPMG, led to the discovery of other segregated account and secured funds violations, these too were largely clerical in nature. The Order itself notes that none of the violations resulted in any customer losses. With the CFTC’s zero tolerance stand respecting violations relating to customer funds, however, such actions still did not stop the imposition of a nearly half-million-dollar fine ($490,000) against MSSB by the CFTC. Further, the more stringent regulations adopted by the CFTC in October last year to enhance the protections afforded customers and customer funds held by FCMs and derivatives clearing organization ensure that segregated account and secure funds violations will continue to be well represented in the CFTC’s enforcement actions.
Review of Segregated Accounts and Secure Funds Requirements
Section 4d(a)(2) of the Commodity Exchange Act (the “CEA”) requires each FCM to segregate from its own assets all money, securities, and other property deposited by futures customers to margin, secure or guarantee futures contracts and options on futures contracts traded on designated contract markets (DCMs). Section 4d(f) of the CEA contains parallel protections for cleared swaps customers in connection with margining cleared swaps. (Note: USC section cites linked to in this post do not always correspond with the CEA section cites.)
Regulation 1.20 implements Section 4d(a)(2) and requires that all futures customer funds must be separately accounted for and may not be commingled with the money, securities or property of the FCM or any other person that is deposited by such customers to margin or guarantee futures trading. Segregated accounts must be titled for the benefit of the FCM’s customers. Further, acknowledgements must be provided that would preclude a bank or clearinghouse from recognizing a right of offset against the account for the FCM’s debts. Part 22 of the CFTC’s regulations contains the similar parallel protections for cleared swaps customers.
Section 4(b) of the CEA permits the CFTC to promulgate similar protections with regard to funds deposited by U.S. customers for trading on foreign markets. Part 30 of the CFTC’s regulations contains some protections that are similar to those for segregated accounts, but in addition requires FCMs to hold apart a “secured amount” for U.S. customers trading on foreign boards of trade through FCMs. The secured amount must be based on the lesser of: (i) margin plus unrealized gains/losses plus long option value, minus short option value; or (ii) net liquidating equity (which includes the market value of the securities deposited).
In addition to the above, FCMs have daily and periodic financial recordkeeping and reporting requirements related to segregated accounts and secured funds.
On April 8, 2013, MSSB erroneously transferred approximately $16 million out of a customer secured funds bank account, resulting in a deficiency in MSSB’s secured funds of approximately $9.27 million. MSSB discovered the error the following day, corrected it, and notified the NFA and the Commission. This was the self-reporting event that caused the CFTC to probe deeper. The Order found that for approximately a six-month period in 2012, MSSB mistakenly commingled $1 million of employee-owned non-customer securities with $43 million of customer-owned securities in a customer segregated account. The Order found that for several months in 2012, account statements for four MSSB segregated accounts were improperly titled as customer secured accounts by the bank, although the required acknowledgement letters properly identified the accounts as segregated. Additionally, for an eight-month period in 2012, MSSB failed to accurately compute its secured funds on deposit at the close of each business day due to: (i) a failure to include open trade equity on certain London Metals Exchange contract; and (ii) an incorrect valuation of Treasury securities. These errors caused collateral value misstatements on 32 of its clients’ accounts. None of these errors caused MSSB to fall below its segregated accounts or secured funds requirements.
This action should serve as a useful reminder respecting the importance of exercising diligence in maintaining the books and records with respect to segregated accounts and segregated funds, as well as the importance of keeping a “two deep” policy with respect to critical books and records functions. The sloppy books and records issues experienced by MSSB not only cost its FCM in terms of the hefty fine, but the painful proctology exam and countless attorney hours that preceded it – resources that would have been better spent preventing such action. There was no violation in this action relating to failing to ensure that customer funds were placed in the segregated accounts, but also the inverse: failing to ensure that non-customer funds were not placed in those accounts either. Furthermore, FCMs need to ensure that the calculation of their secured funds balances, as well as their segregated account balances, is not only regularly reviewed but also fully reviewable.
CFTC Actions for Segregated Account & Secure Funds Operations Related Violations
ADM Investor Services (September 2013) for commingling customer and proprietary funds in non-customer segregation accounts. Fine: $425,000
Vision Financial (September 2013) for failing to segregate commodity and options customer funds, failing to notify the CFTC of the under-segregation and making misstatements to the CFTC about the location and the manner in which the customer funds were being held. Fine: $525,000
R.J. O’Brien (September 2013) for commingling foreign futures and options customer funds with segregated domestic futures and options customer funds. Fine: $125,000
Macquarie Futures (September 2013) for failing to maintain adequate funds in secured accounts in connection with the re-designation by ICE Clear Europe of certain secured funds to segregated funds (OTC derivatives were converted to U.S. exchange listed futures and options). Fine: $150,000
ABN Amro Chicago (June 2013) for segregated and secured fund deficiencies (among other books and records violations, minimum net capital violations and supervision failures). Fine: $1,000,000
Interactive Brokers LLC (April 2013) for failure to maintain sufficient U.S. dollars in customer segregated accounts, as well as failure to compute on a currency-by-currency basis the amount of customer funds on deposit and required to be on deposit in segregated accounts. Fine: $225,000
Mizuho Securities USA (January 2013) for secured account fund deficiencies (despite having a segregated account excess), failure to file timely notice (Mizuho waited five days), and related supervision failures. Fine: $175,000
Cantor Fitzgerald (November 2012) for allowing customer funds to become under-segregated for three days due to improperly transferring funds out of a segregation account instead of its house account, as well as for failing to notify CFTC of the under-segregation. Curiously, this incident because the person in charge of determining customer segregation accounts was out (hence the importance of maintaining a “two deep” policy for critical segregation account and secured fund maintenance functions. Fine: $700,000
JP Morgan (April 2012) for improperly including in customer segregated funds in Lehman Brother’s calculation of its net free equity. Fine: $20,000,000
MBF Clearing Corp. (March 2012) for holding segregated customer funds, over a twelve month period, in an improperly titled non-segregated account that did not have a legal obligation to make such funds available within one business day. Fine: $650,000