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Valuable compliance lessons from Scotiabank's $127 million penalty

NEW YORK(Thomson Reuters Regulatory Intelligence) - *To read more by the Thomson Reuters Regulatory Intelligence team click here: bit.ly/TR-RegIntel

A commuter passes a branch of Scotiabank in the PATH underground walkway in Toronto, Ontario, Canada March 16, 2017.

A top Canadian bank and a major participant in the gold markets has agreed to pay more than $127 million to resolve U.S. regulatory and criminal charges. The settlements announced last week by the U.S. Commodity Futures Trading Commission (CFTC) and the U.S. Department of Justice (DOJ) spanned an eight-year period and involved thousands of manipulative orders by four traders at the Bank of Nova Scotia, also known as Scotiabank.

The charges centered around the manipulative trading practice commonly known as “spoofing.” Regulators also charged that the bank made false statements and incomplete disclosures about the alleged price manipulation by its traders in the futures markets for precious metals.

The steep penalties and settlements which require the bank to retain an independent compliance monitor reflect the seriousness of the alleged missteps. The settlements also roughly coincide with a decision to wind down its metals business. In April, Reuters reported that Scotiabank informed staff that it would be closing its metals business by around the start of 2021, according to sources familiar with the matter.

The winding down of the business is noteworthy as it draws the curtain on what was for years the world’s biggest lender to the physical precious metals industry, with a history stretching to the founding in 1684 of London gold dealer Mocatta Bullion.

Below we recap the settlements with the CFTC and DOJ with an emphasis on the alleged compliance supervisory failures.

SCOTIABANK’S SETTLEMENTS WITH THE CFTC

In the press release announcing the settlements{here}, CFTC Chairman Heath P. Tarbert said the "record-setting penalties reflect not only our commitment to being tough on those who break the rules but also the tremendous strides the agency has made in data analytics." The regulator's ability to go through the electronic order book and look across markets enabled the CFTC to not only spot misconduct, but also uncover false and misleading statements, Tarbert said.

CFTC Director of Enforcement Division James McDonald said, “We now have the tools, including through the development of our data-analytics program, to better test and verify the information we receive. When entities are not completely truthful, they will be penalized.”

The CFTC settlements were separated into three orders. The first order covered the spoofing violations. The second order addressed the false statements to the regulator in relation to a 2018 settlement for spoofing where the bank paid a penalty of $800,000{here}.

The third order addressed alleged failures to comply with swap dealer business conduct standards dating back nearly eight years. The CFTC said Scotiabank’s pre-trade mid-market marks (PTMMMs) were inaccurate, untimely, or both. In some instances, it failed to provide PTMMMs entirely. The CFTC said this conduct had the effect of concealing its full markup from its swaps counterparties. The CFTC also cited the failures in the counterparty onboarding process, PTMM, audio recordkeeping, and chief compliance officer reporting failed to comply with pertinent regulations.

The CFTC also found that Scotiabank made false or misleading statements to the CFTC during its investigation.

The first two orders resulted in a $77.4 million penalty, which was comprised of a record-setting $17 million penalty for making false and misleading statements to CFTC staff during the CFTC’s initial spoofing investigation and a record-setting penalty of $42 million for spoofing and attempted manipulation. Scotiabank was also required to pay $6,622,190 in restitution and $11,828,912 in disgorgement, and to retain an independent monitor.

The third order related to the swap dealer business conduct failures which resulted in a $50 million civil monetary penalty and required the firm to retain an independent monitor. Furthermore, the CFTC said the bank “acknowledges that the findings of the order provide the Commission sufficient grounds to commence proceedings to suspend or revoke BNS’s registration status, but the Commission defers commencing such proceedings on the condition that BNS fulfills its obligations relating to registration, remediation, and the monitor.”

RELATED CRIMINAL ACTION

In a parallel action, the DOJ announced the entry of a Deferred Prosecution Agreement (DPA) with Scotiabank{here}, which deferred criminal prosecution on charges of attempted price manipulation and wire fraud. Scotiabank agreed to pay $60.4 million in criminal fines, forfeiture, and restitution to victims. Part of the monetary penalty is credited against payments made to the CFTC.

“For over eight years, Scotiabank traders placed thousands of orders for precious metals futures contracts in an attempt to manipulate prices for their own and the bank’s benefit and to deceive other market participants,” said Chief Robert A. Zink of the Justice Department’s Criminal Division, Fraud Section. The agreement “includes a criminal monetary penalty at the top of the United States Sentencing Guidelines range, money to compensate victims, and an independent compliance monitor—reflects the seriousness of the offense and the state of Scotiabank’s compliance program, and further helps to promote the integrity of our public markets,” Zink said.

The DOJ commended Scotiabank, saying it “has made significant investments to improve its compliance technology and trade surveillance tools, has nearly doubled its annual compliance operating budget, has added more than 200 full-time equivalent compliance positions, and is in the process of winding down its precious metals business.” Despite the efforts thus far, DOJ still felt an independent compliance monitor was necessary because “Scotiabank’s remedial improvements to its compliance and ethics program have yet not been fully implemented and tested to demonstrate that they would be effective in detecting and preventing similar misconduct in the future.”

CFTC EMPHASIS ON SPOOFING

The manipulative trading practice known as "spoofing" has emerged as a top regulatory enforcement priority with the CFTC. The CFTC and the largest futures exchange, the CME, were empowered to crack down on spoofing under Section 747 of the 2010 Dodd-Frank Act{go-ri.tr.com/OOlTs1} which amended the Commodity Exchange Act to make it unlawful to engage in any trading, practice or conduct that "is of the character of, or is commonly known to the trade as, 'spoofing' (bidding or offering with the intent to cancel the bid or offer before execution)."

Spoofing is a form of market manipulation, often using computer algorithms to rapidly display and cancel orders just before execution. It can be carried out hundreds or even thousands of times daily. It can also be done manually, and the CFTC has cautioned that “even a single instance” of spoofing could constitute a violation.

The CFTC began by publishing interpretive guidance in 2013 on spoofing and other disruptive trading practices{here}. The CFTC guidance clarified that a spoofing violation requires a market participant to act with some degree of intent beyond recklessness. It also states that legitimate, good-faith cancellation or modification of orders or properly placed stop-loss orders would not be considered unlawful spoofing. In order to distinguish legitimate trading from spoofing, the CFTC would evaluate the market context, the person's pattern of trading activity, including fill characteristics and other relevant facts and circumstances.

The prohibition on spoofing covers “bid and offer activity on all products, traded on all registered entities.” The CFTC provided examples of unlawful spoofing, such as creating an appearance of false market depth, delaying another participant’s executions, activity that could overload the quotation systems, and submitting or canceling bids or offers with the intent to create artificial price movements upward or downward.

In the past several years, the CFTC has had an impressive string of successful settlements against firms racking up significant fines. However, victories in the courtroom against individuals have not been nearly as easy. After winning a conviction against Michael Coscia in 2016{here}, where he was sentenced to three years, the DOJ has lost two other cases. The most significant setback occurred when the DOJ lost a jury verdict against a former UBS precious metals trader in April 2018. That verdict came in federal court in New Haven, Connecticut, where Andre Flotron, a former top precious metals trader at UBS was acquitted{here}. The verdict was surprising in that it came a few months after UBS agreed to pay a $15 million civil penalty as UBS self-reported the alleged misconduct by its traders to the regulator.

COMPLIANCE TAKEAWAYS

Compliance departments should thoroughly review and be sure to gain a complete understanding of the trading programs or algorithms being used. Firms need to adopt controls such as pre-trade risk controls and order cancellation systems.

A review should begin by focusing on trading strategies that deploy algorithms, involve a high volume of market activity, and have lower fill rates. Firms should consider whether any activity could raise red flags for regulators, especially if trading algorithms call for cancellation of bids and offers and be sure to document the reasoning behind cancels.

A review of cancellation of bids and offers is especially important in pre-market and opening and closing periods. There also needs to be a review to see if there is any connection between cancellation activity and market prices.

Compliance professionals will need to develop, test, and monitor in real-time any algorithms and trading activity. They should also be sure to test the algorithm before it is used and have a real-time monitoring system for the trading algorithms.

The misuse of chat rooms has been a central component of many cases where market manipulation, collusion, or spoofing was involved. The electronic record of communication has proven to be a proverbial smoking gun for prosecutors and regulators in a string of cases, which is likely to continue.

The CFTC has moved towards aligning itself with law enforcement and other regulators regarding cooperation credit and self-reporting. This may require compliance departments to review policies and procedures in commodity businesses so that they are aligned with other areas if not already.

With an increased awareness surrounding trading desks and quality of executions, compliance officers must review policies and procedures and stay abreast of the evolving and technology-driven trading landscape.

Perhaps the biggest takeaway from the Scotiabank case is the severity of the penalty. The steep fines and what amounts to a death penalty as the firm has announced the shutting down of the trading business sends a strong message for the need for truthfulness and cooperation from compliance departments in investigations. The false or misleading statements related to the prior settled action were undoubtedly significant factors in determining the severity of the penalties.

(Todd Ehret is a Senior Regulatory Intelligence Expert for Thomson Reuters in New York.)

This article was produced by Thomson Reuters Regulatory Intelligence - bit.ly/TR-RegIntel - and initially posted on Aug 28. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @thomsonreuters

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