Managed Futures Education Center

(Note: This article was altered 1/30/2012 to reflect new information, and was introduced in Congressional testimony by Congressman Posey on February 2, 2012.  

This is the first of several articles that details questionable, behind the scenes meetings and special treatment that negatively impacted investor protections.  This first article details a critical meeting where core investor protections were jeopardized.  The second article details tampering of critical MF Global documents at the SEC.  The third article provides names, dates and topics of critical meetings that took place between government regulators and Mr. Corzine that likely influenced the outcome of regulatory action.) 

In Closed Door Meeting Preceding Bankruptcy Filing, Little Known Technical Detail May Have Set Chilling Precedent and Potentially Jeopardized Integrity of Futures Markets while Top CFTC Official Was Apparent Bystander

A key legal protection providing security to the account segregation process might have been given away in a closed door meeting between the Commodity Futures Exchange Commission (CFTC) and Securities and Exchange Commission (SEC).  It seems ironic that after all is said and done, it was a hasty pre-dawn conference call between government regulators on October 31, 2011 that may have sealed the fate of MF Global segregated account protections – and may have placed in jeopardy the integrity of the futures markets.[1]

It was here a little discussed legal technicality usurped the common Chapter 7 Bankruptcy Code, which has very specific language protecting MF Global segregated account holders.  It is this language, in subchapter IV where legal experts say the very foundation that the integrity of the futures markets and its “segregated account comes before all else” claim may rest.

Instead of utilizing the Chapter 7 bankruptcy, the SEC and CFTC put the liquidation process into what is known as a SIPA (Securities Investors Protection Act) liquidation.  A SIPA liquidation is designed primarily for securities accounts, not futures accounts.  Legal sources say the fact that over 36,000 futures accounts were impacted vs only 318 securities accounts is significant cause to question this move. Further, legal sources say the securities accounts had insurance and they were not in deficit, so therefore there should be no conflict for following the futures rules.  While some legal sources have indicated that a SIPA liquidation process is considered the “only” choice for a liquidation involving a BD / FCM, highly placed industry observers disagree, particularly with the core integrity of the futures markets at stake.  The court has asked the MF Global bankruptcy trustee, the CFTC and the SEC to submit briefs regarding the allocation and distribution in the MF Global estate. The CFTC has already filed a brief arguing in favor of the sanctity and priority of customer funds.

“In the Sentinel liquidation process (another bankruptcy liquidation process involving the CFTC and SEC with slightly different circumstances), the regulators  argued over the bankruptcy liquidation method in court,” noted Chris Hehmeyer, Vice Chairman of the Board of Directors of the National Futures Association, the industry regulatory authority similar to FINRA on the equities side of the business.  “The court clearly sided with the CFTC in this instance,” said Hehmeyer, who is also currently president of proprietary trading firm HGT Capital and former president of Pension futures.  “The CFTC fought for the commodities industry then.  The industry wants to know where were they were with MF Global?”

There are credible claims being made the SIPA liquidation process does have provisions that allow for segregated account protections, according to Andrea Corcoran, a former CFTC official who crafted the Bankruptcy Code for liquidation of Broker Dealers and Futures Commission Merchants.  However, the “iron clad” aspects of these protections are currently a question mark, as the court and trustee appear to be favoring equal treatment for segregated account holders and general creditors.  In a statement defending the decision to move the bankruptcy into a SIPA liquidation on January 27, CFTC commissioner Jill Sommers stated: “Many have questioned why an FCM bankruptcy would take place in a proceeding under the Securities Investors Protection Act of 1970 (SIPA). Under SIPA, the Securities and Exchange Commission (SEC) has the authority to refer an entity registered as a broker-dealer (BD) (whether or not such entity is also registered as an FCM) to the Securities Investors Protection Corporation (SIPC) if there is reason to believe that the entity is in or is approaching financial difficulty.”

(For full release: http://www.cftc.gov/PressRoom/SpeechesTestimony/opasommers-20)

The court has asked the MF Global bankruptcy trustee, the CFTC and the SEC to submit briefs regarding the allocation and distribution in the MF Global estate. The CFTC has already filed a brief arguing in favor of the sanctity and priority of customer funds. On January 18, the Commodity Futures Trading Commission (CFTC) filed a legal brief essentially supporting the superiority of MF Global segregated account holders over creditors in a SIPA liquidation, citing specific bankruptcy code case law that afforded MF Global segregated account holders superiority over creditors.

(For full release: http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/cftcreplybrief011812.pdf)

Recognize the Significance: Was the War Was Won Before a Legal Argument Hit the Ground?

According to legal experts close to the situation, the significance of moving to a SIPA liquidation process cannot be under-estimated.

“The SIPA decision has significant political implications beyond the under-handed move to place customers at a disadvantage relative to general creditors,” observed compliance consultant Bob English, contributing editor to EconomicPolicyJournal who writes a blog at english.economicpolicyjournal.com. “Gensler’s CFTC put markets at risk by agreeing to hand MF Global Inc. over to SIPC, which was ill-equipped to liquidate a futures broker.  Where were the CFTC attorneys when that decision was made?  The CFTC was not doing its job and will have to answer for it.  With enough political pressure, there is a chance it can clean up the mess it made.”

This is important because many Futures Commission Merchants (FCMs) have access to significant residual value in accounts and clearing relationships despite the bankruptcy.  This is why Interactive Brokers was negotiating to acquire MF Global over Halloween weekend 2011, which resulted in the chilling realization that the sanctity of account segregation may have been violated.  This is a violation so serious in the commodities industry it immediately made MF Global radioactive.  Don’t forget, this is when Interactive Brokers immediately dropped plans for the acquisition when revelations of segregation violations were known and CFTC Chairman Gensler “made it clear that Interactive Brokers would have to take over all of MF Global’s positions and guarantee both the positions and the collateral.”[2]

Sources close to the situation say that even without a buyer for the brokerage business, it wouldn’t matter if a standard liquidation under the Commodities Exchange Act (CEA) and with a Chapter 7 liquidation were chosen, which is the required method for a FCM liquidation.  This is because the accounts would have gone to the Chicago Mercantile Exchange (CMEGroup), for assignment to member FCMs.  And if money is missing the difference – estimated at 11% at the time – is sent to customers after the liquidation of MF Global, where segregated accounts receive top priority in a liquidation.  That is how the CEA is written, how the integrity of the commodities markets are protected.  This is what was given away in an early morning meeting that is yet to be made public.

What May Have Been Given Away in the Meeting: Account Segregation Protection

The futures industry has always been proud to crow of its impeccable record that “No customer has ever lost money to fraud or bankruptcy in a segregated account.”  During the MF Global bankruptcy process, as industry participants considered that “segregated accounts come before all else in a liquidation,” many including myself expressed bold confidence MF Global segregated account holders would receive 100% of their titled property back. This confidence was perhaps most famously expressed when Mr. Hehmeyer and exchange reporter Rick Santelli ended their interview on MF Global client recovery process by joking “They know how much the clients will receive.” 

This confidence was not based on bravado, but rather deep industry knowledge.  The fundamental principal behind the “sanctity of the segregated account” and the integrity of the futures markets is assured under federal law by both the Commodity Exchange Act (CEA) and the U.S. bankruptcy code.

The absolute significance of account segregation and legal protections as it relates to the integrity of the futures markets is a core pillar of the industry, which makes the CFTC / SEC meeting giving away these protections away that much more curious.

The problem was, the decision to weaken segregated account protections took place early in the morning behind closed doors.  In a critical meeting it appears as though no one was protecting the integrity and safety of the commodities markets.

The Non-Transparent Meeting History Should Record

While the meeting deliberations remain private for now, sources say in the early morning hours of October 31, 2011, as the world was about to collapse all around MF Global in one of the most frenetic mornings in recent memory, a non-descript conference call took place behind closed doors.  It was here that two paths were laid out.  On path was the expected path that assumed a Commodity Exchange Act (CEA) liquidation process which protected MF Global account holders.  The other path, the Securities Investor Protection Corporation (SIPC) route, protected MF Global creditors such as JP Morgan and Goldman Sachs.

How ironic that the entire fate of the commodities markets – and their critical account segregation protections – might have rested on one phone call in the early hour fog of a soon-to-be bankruptcy laced with fraud charges.  Normally the process of determining a bankruptcy process is much more deliberate, according to legal experts.  One might have thought that might be the case where the very integrity and safety of the futures markets were at stake with one of the largest bankruptcies in history.  But no, the meeting participants knew exactly what was at stake and where the paths led – it wasn’t until later that the futures industry began to realize it had been sold down the river by a slick equity market lobbyist.

While meeting participants are still as of yet not officially confirmed, sources close to the situation say that the key participant was Robert Cook, the SEC’s Director of the Division of Trading and Markets.  Mr. Cook’s predecessor at the SEC also made the critical decision to put Lehman Brothers into a SIPC liquidation.

Full press release of Mr. Cook’s appointment to the SEC: http://www.sec.gov/news/press/2009/2009-242.htm

Before joining the SEC, Mr. Cook was a partner at the powerful Washington D.C. law firm of Cleary Gottlieb Steen & Hamilton LLP, which represents JP Morgan, among other clients.  Mr. Cook is acknowledged by the law firm’s web site that he is one of the top securities regulation lobbyists in the country, “a significant contributor to our securities regulation and transaction practice” and “…one of the leading practitioners on broker-dealer market regulation in the United States.”

Full release on Mr. Cook: http://www.cgsh.com/cleary_gottlieb_partner_robert_cook_to_join_sec_as_director_of_division_of_trading_and_markets/
So the score card on this heavy weight fight is lining up nicely.  In this corner we have Mr. Cook, an apparent proud lobbyist whose firm has significant ties with creditors.  And in the corner representing the commodity industry and investors protections we have…

With the Integrity of the Futures Markets In Jeopardy, Where Was the CFTC? 

The CFTC’s most significant mandate, according to their web site, is to protect the integrity of the futures markets, thus their attendance in a meeting where core market protections were being given away would have been mandatory. One would further conclude that the CFTC would fight to protect MF Global segregated account holders and uphold the integrity of account segregation.  While regulatory officials point to segregated account protections in the SIPA liquidation process, the fact that such protections are currently in jeopardy illustrate the problem.

Speculation is that CFTC Commissioner Jill Sommers, who was later named Senior CFTC Commissioner with respect to MF Global issues on November 9, was the key liaison at the meeting for CFTC Chairman Gary Gensler, who likely made the key decisions, according to sources.

“There was no logic behind making this a SIPA liquidation,” stated futures industry consultant Elaine Knuth, who contributes to a blog at www.mfgfacts.com.

In Congressional testimony in front of the Committee on Agriculture on December 8, Commissioner Sommers acknowledged the CFTC agreed with the Mr. Cook’s decision to favor a SIPA liquidation over a standard bankruptcy protection with protections for segregated accounts. Acknowledging the discretionary nature of such a decision, Ms. Sommers qualified her comments by saying “As I understand (emphasis added) the Securities Investors Protection Act of 1970 (SIPA), the SEC has the authority to refer an entity… to the Securities Investors Protections Corporation (SIPC)” for liquidation proceedings.

Link here for full statement:

http://agriculture.house.gov/pdf/hearings/Sommers111208.pdf

Integrity and Safety of Futures Markets Should Have Trumped Creditor Interests

While legal issues across jurisdictions are less than clear, the importance of segregated account protections relative to the integrity of the futures markets should have trumped the commercial interests of JP Morgan, Goldman Sachs and other creditors, according to legal experts.

“What is clear is under its Congressional mandate, the CFTC should have absolutely prevented market disruption and freezing customer assets by a Securities Industry, SIPC liquidation and immediately asserted special priority distribution of such property under the US Bankruptcy Code contained in section 7,” noted Ms. Knuth.  “For the CFTC to give up and throw away critical market protections and allow that to happen in this case is not only absurd to the highest degree, it questions why then the agency even exists?”

The entire futures industry and its regulators have proudly made the statement that “In a segregated account, no client has ever lost money to fraud or bankruptcy of an FCM.” This is due in large part to the reliance on a bankruptcy liquidation using standard Bankruptcy Code where client segregated funds come above all else.  Consider the integrity of the entire futures market system of account segregation is currently hinging in part on legal rights contained in Subchapter IV of Chapter Seven of the Bankruptcy Code.  The section titled “Commodity Broker Liquidation” was designed to assure investor segregated funds are always sacrosanct. Futures market security might have been subverted with a quick back-room slight of hand.

In her second testimony before congress, commissioner Sommers stated that the bankruptcy was “required” to move into SIPA liquidation, a fact which Ms. Knuth and other legal experts question.

“The fact that the SIPA liquidation was selected is baffling enough given the almost non-existent number of securities accounts,” she said. “But what is the most bizarre aspect of the story is the CFTC allowed this liquidation to occur under SIPA, without asserting their own Congressionally mandated authority to protect the markets and futures customers.”

“A crime has occurred on several levels,” she said.  “We need to know why and how it was done, and no one seems to be asking the right questions and instead looking for disputed amounts of missing money under the cushions.”   Ms Knuth and the industry are all asking questions:

1. Who at the CFTC was involved in that decision?
2. Did the CFTC take steps to assure that a US Trustee with experience in the industry was assigned?
3. Was the CFTC involved in assuring that the dualy registered entity with almost 100% commodity accounts would apply the relevant protections of the Bankruptcy code and CEA to the proceedings?
4. Why is the CFTC only now asserting that “the relevant provisions and protections of the Bankruptcy Code, the Commodity Exchange Act (“CEA”), and the Commission’s regulations apply to commodity accounts just as they would if the entity were solely an FCM…”

 Footnotes: 

1)      The date of the SEC / CFTC decision date has been documented as October 31, 2011 by Futures Magazine, who notes in the article MF Global Failure Highlights Cracks In the System, and seemed to indicate that a deliberate decision took place with the words on page 47: “The CFTC announced ‘that a SIPC-led bankruptcy would be the safest and most prudent course of action to protect customer accounts and assets.”  This would lead me to believe there were other choices considered?  We need to get into those meeting minutes.

2)      http://www.marketwatch.com/story/cftc-still-trying-to-explain-mf-customer-shortfall-2011-11-03

3)      Readers are advised to view an article to be published 1/23/2012 where former CFTC director Andrea Corcoran outlines SIPA liquidation protections similar to a Chapter 7 liquidation.

http://go2managedfutures.com/2012/01/architect-of-broker-dealer-fcm-liquidation-process-goes-on-the-record-regarding-sipa-liquidation-process/

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