Financial Regulatory Forum

Futures customer protections improved in U.S. and overseas after frauds

By Guest Contributor
July 17, 2012

By Nick Paraskeva

NEW YORK, July 17 (Thomson Reuters Accelus) - The CFTC approved tough customer protection rules for futures firms’ days after the Peregrine default led to over $200 million in missing client funds. Losses arising from a fraud by the owner of the futures broker come soon after a $1.6 billion hole in client funds from the collapse of MF Global. The new rules require daily calculations of client money to be reported, and for senior management to certify cash movements.

The CFTC charged Peregrine Financial Group, and its owner Russell Wasendorf, Sr, of misappropriating customer funds. A recent audit of Peregrine by the National Futures Association (NFA), the self-regulator for independent futures firms, found the firm falsely represented it held $220 million customer funds at a bank account, which only had $5.1million. The firm filed for liquidation Friday, and its owner was arrested.The alleged bank account falsification began in 2010, and the owner admitted fraud in a letter found when he attempted suicide. The fraud was discovered when NFA confirmed the balance directly with the bank. The liquidation trustee is authorized to operate the business for a time to distribute customer statements, but “it is not clear when the trustee will be authorized to release any funds to customers”, said the NFA.

The CFTC on Friday approved NFA rules to improve protection for customer funds at futures commission merchants (FCMs). The rules were proposed as a response to missing client funds at MF Global. Despite some calls, such as from CFTC Commissioner Chilton for a futures insurance fund similar to SIPC, the Futures Industry Association (FIA) instead backs beefed up disclosure to customers and internal controls.

“While an individual bent on fraud can confound even the most sophisticated compliance framework, measures to mitigate the risk of fraud must continue to be vigorously pursued” said the FIA two days after the Peregrine fraud came to light. “A combination of robust internal controls, enhanced audit procedures and oversight, and vigorous enforcement gives us all the best chance at combating this type of fraud”.

Foreign and U.S. Markets

The new rules strengthen controls over funds for customers trading on both U.S. markets (segregated accounts), and funds held for foreign futures and option customers on foreign markets (Part 30 accounts). A lack of segregated funds on foreign activity was identified as a cause of the shortfall at MF Global, and the resultant gap at the MF group level subsequently ended up harming the firm’s U.S. customers.

The calculation will now require a firm to have enough funds in their Part 30 accounts to meet all their obligations to customers on foreign markets. The amount segregated is to be computed under the ‘net liquidating equity method’ and represents total balances owed to customers. Firms are no longer allowed to use the ‘alternative method’ as this can produce lower amounts based on foreign margin requirements.

Last month’s report by trustee James Giddens on the collapse of MF Global recommended that the CFTC abolish the ‘alternative calculation’ method, and require segregation over 100 percent of customer funds. This would then result in the funds of customers on foreign exchanges being given the same level of protection as those in the U.S. The new NFA rules appear to be consistent with the trustee’s recommendation.

Approval and Notification for Withdrawals

The rules will require a firm to have policies and procedures on their maintenance of excess segregated funds not for the benefit of customers. Policies must target the amount the firm seeks to maintain, either in percentage or in dollar terms. There is also a new requirement for a senior manager such as the CEO or CFO, to pre-approve in writing any disbursements of over 25 percent of the firm’s excess segregated funds.

The firm is then required to immediately file a notice of the disbursement with NFA signed by the CEO or CFO that confirms their pre-approval. The filing should also state the reasons for the disbursement, the amount paid out, who the recipients of the funds were, and the firm’s remaining excess in the account.

The rule aims to get senior management to certify approval of large transfers from client accounts at the time they are made. It is also known as the ‘Corzine rule’, named after the eponymous CEO of MF Global. After MF Global’s collapse, senior management including the CEO did not acknowledge they knew of, or had directed, the cash movements made out of client funds accounts in the final days of its existence.

More Frequent and Detailed Financial and Client Money Reports

Futures firms will now be required to file their client money segregation computation on a daily basis with the NFA. This is to be filed electronically by noon, based on positions at close of the preceding business day. Firms are also required to file, on the 15th and last business day in each month, the depositories that it uses for client assets, and the permissible investments that have been made with customer funds.

A firm is also required to file monthly with the NFA its net capital and excess capital positions, the level of balance sheet leverage it has, and whether any of the depositories used are group affiliates. The NFA is planning to make some of the financial information received from firms publicly available on its website. The aim is to allow clients to make better informed decisions when choosing which futures firm to use.

It is notable that the new senior manager sign-off, on its own would have been unlikely to have stopped the Peregrine fraud, given that the founder and owner of the firm was directly involved. Similarly, the new financial reporting requirements appear to respond to MF Global, which had capital problems prior to its collapse and used unregulated affiliates, which were not the case in the outright fraud at Peregrine.

There may now be further calls for specific rules that will directly respond to the Peregrine case.

James Giddens, the Trustee for MF Global, last month recommended the creation of a protection fund for futures and commodities customers, based on a certain dollar threshold. He also recommended suitability standards for customers of futures firms that would be similar to those imposed by the SEC and FINRA.

“A protective fund of this nature could be modestly funded and maintained at a minimal cost until such time as necessary to advance funds to customers, thereby allowing them to resume trading with little or no delay”, said Giddens. “The fund could be replenished by industry assessments when needed to satisfy claims in FCM failures”.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. <a href=”http://accelus.thomsonreuters.com/solut ions/regulatory-intelligence/compliance- complete/” target=_new”>Compliance Complete</a> provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges.)

(Nick Paraskeva is principal of Reg-Room LLC (www.reg-room.com), which provides regulatory information and consultancy. He covers various facets of the banking and securities industry and delivers exclusive analysis through Thomson Reuters. He can be contacted at (212) 217-0403 and nparaskeva@nyc.rr.com. Follow Nick on Twitter@regroom.)

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