Gary DeWaal and Associates LLC

Bridging the Week by Gary DeWaal: June 16 to 20 and 23, 2014 (Two Federal Entities Fight; CCPs; Collateral; Canadian Investment Funds; and Whistleblowing)

Bridging the Week   
Published Date: June 22, 2014

Last week it was speeches by key regulators; this week, reports provide the food for thought regarding certain worldwide financial industry trends, including repercussions of directing more trades to central clearing houses and the potential future scarcity of high value collateral. In addition, the US Securities and Exchange Commission commenced a subpoena enforcement action against a committee of the US House of Representatives and one of its employees, and brought its first enforcement action against an SEC registered firm and its owner for retaliatory actions taken against a whistleblower.

As a result, the following matters are covered in this week’s Bridging the Week:

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SEC Sues House Committee and Employee to Compel Responses to Subpoenas Related to Insider Trading Probe

Two parts of the federal government duked it out in a US court in New York City last Friday.

The US Securities and Exchange Commission sought the court’s assistance to compel the Committee on Ways and Means of the US House of Representatives and Brian Sutter, the Staff Director of the Committee’s Health Subcommittee, to comply with subpoenas that previously had been served, seeking certain documents; the subpoena served on Mr. Sutter also sought his testimony. According to court papers filed by the SEC, respondents failed to answer their subpoenas, claiming that the SEC’s demands were “repugnant to public policy” and a violation of the Speech or Debate clause of the US Constitution, among other reasons.

The subpoenas had been served by the SEC as part of an ongoing investigation to determine whether information related to the April 1, 2013 announcement by the US Centers for Medicare and Medical Services (CMS) regarding reimbursement rates for the Medicare Advantage program was improperly leaked to certain members of the public prior to CMS’ formal announcement, and whether this action resulted in illegal insider trading under US securities laws. (Medicare is a US national social insurance program that provides health insurance for most Americans 65 and over and certain other persons.)

Prior to CMS’ formal announcement, it had been anticipated in the marketplace that reimbursement rates to certain health care insurers would decline from the prior year. However, CMS announced increased reimbursement rates.

Just 20 minutes prior to CMS’ announcement, claims the SEC, an analyst at one broker-dealer issued a “flash report” predicting the reversal in the marketplace expectation and CMS’ ultimate announcement. This report was sent to many of the broker-dealer’s clients, including many investment funds. Stock prices of affected health care insurers began to rise dramatically.

Prior to the analyst’s issuance of his flash report, he received an email from a lobbyist that forecasted CMS’ actions, claiming he heard the information “from very credible sources.” The SEC opened its investigation to try to determine the source of the information received by the lobbyist. The lobbyist told the SEC he spoke to Mr. Sutter approximately 10 minutes prior to sending his email to the analyst, and that they spoke about the pending reimbursement rate increase during their conversation. The SEC claims it has other information too that suggests that Mr. Sutter was the source of the lobbyist’s information.

In response, the SEC first sought a voluntary production of documents from the Committee and Mr. Sutter. After this effort was unsuccessful, the SEC issued its subpoenas on May 6, 2014.

The SEC, in its court papers, argues that the Speech or Debate clause of the US Constitution is inapplicable to respondents. This clause, which states that “for any Speech or Debate in either House, [members of Congress] shall not be questioned in any other place,” applies to legislative acts only, says the SEC, or activities that are “an integral part of the deliberative and communicative processes.” According to the SEC,

“Any enforcement proceeding that results from this investigation would address the disclosure of material nonpublic information regarding imminent action by an agency of the Executive Branch, not any act or conduct that fits within the definition of ‘legislative act’ adopted by the [US] Supreme Court.”

The SEC also argues that there is no basis to preclude Mr. Sutter’s testimony.

“[S]utter has ‘unique first-hand knowledge’ of the facts central to the [SEC’s] investigation and ‘the necessary information cannot be obtained through other, less burdensome or intrusive means.’ Under such circumstances, it is settled law that [there is] no excuse from testimony.”

According to a published report, the Hon. Paul Gardephe, the US judge hearing this matter, ordered the Committee and Mr. Sutter to respond to the SEC’s papers by June 26, and for all parties to reappear before him on July 1. (For more color on Friday's court hearing, see article “SEC Files Lawsuit to Enforce Subpoenas Issued to Congress” in The Wall Street Journal on June 21 by clicking here.) 

IOSCO Publishes Results of Survey of Securities Markets Risk Trends; LSE and DTCC Publish Report on Collateral Demand in the Evolving Marketplace

In its Survey of Securities Markets Risk Trends 2014, the Research Department of the International Organization of Securities Commissions summarized the results of an in-depth survey of both industry leaders and regulators regarding their views on risks to and within global securities markets. Not surprisingly, risk assessments by regulators and industry personnel differed. While regulators were most concerned about risks arising from illegal conduct and breakdowns in corporate governance, financial risk disclosure and benchmarking, industry participants were more concerned about the search for yield, resolution and recovery plans, central clearing houses and market fragmentation.

Separately, the London School of Economics and the Depository Trust Clearing Corporation published a study related to the use of collateral assets as a result of regulatory reform and changing market practice. The report concludes that overall there is sufficient collateral worldwide to meet projected demand. However, weaknesses in market infrastructure may likely cause collateral to be immobilized in one part of the system when it is needed in another part, at least temporarily.

In the IOSCO commissioned survey, there was a clear distinction between the concerns of market participants and regulators. According to the survey,

“Regulators are more concerned with issues of disclosure and conduct while market participants are clearly focused on changes in market behavior. Predominantly regulators see risk emanating from illegal conduct, poor corporate governance, financial risk disclosure and benchmarking issues, while only a small fraction of financial market participants recognize these topics as potential risk areas. Market participants are more concerned with risk in the areas of search for yield, resolution and resolvability plans, CCPs and market fragmentation.”

Regarding central clearing houses, respondents expressed concern about “forcing markets to concentrate large risks into [clearing houses] that are becoming too big to fail.” According to the survey,

“By creating new systemically important infrastructures that are inadequately capitalized for a crisis situation plus a lack [of] recovery and resolution plans implies CCPs may not be as safe as first thought. The primary requirement of central clearing should be to ensure transactions are always honored and the recovery of a CCP should not rely upon the haircutting of end-investor variation margin as this will be pro-cyclical, potentially escalating any financial distress, in the opinion of survey participants. Finally, CCPs may create incentives to clear products that, in the search for new business, should not be cleared.”

There appeared to be consensus among both regulators and industry participants that high frequency trading posed “challenges” to regulators although the consequences “may be hard to fully assess.” Concern was expressed regarding the potential for market abuse as well as if market confidence was diminished because of a belief that some were “gaming the market at the expense of investors.”

Finally, respondents to the survey expressed concern that uncoordinated regulation could cause market fragmentation “which will impact on liquidity levels and trading volumes.” Moreover, a fragmented market was likely to increase costs and complexity in trading, according to the survey.

Separately, the LSE and DTCC report also raised concerns regarding “the move toward centralized clearing and standardized platforms” because of the new paradigm’s increased collateral demand for initial margin. According to this report,

“A system relying principally on centralized clearing to mitigate counter-party risks creates increased demand for liquidity to service frequent margin calls. This can be met by opening up larger liquidity facilities, but indirectly this requires more collateral. To economize on the use of collateral, agents will try to limit liquidity usage, but this implies increased frequency of margin calls. This increases operational risks faced by CCPs which, given the concentration of risk in CCPs, raises the possibility that an idiosyncratic event could spill over into a system-wide event.”

The LSE and DTCC report concludes that while there are likely sufficient high quality assets outstanding worldwide to meet the anticipated demands of collateral going forward, this analysis is based on the assumption that collateral can circulate freely within the financial system. To a certain extent, this may not be true because certain collateral that may be considered high value at any one time – such as certain sovereign debt – may be downgraded at another time. Also, certain historic collateral transformation abilities of large banks are being eroded by “increased regulatory constraints.” Accordingly, says the report,

“The search for new methods of achieving economical collateral transformation is giving opportunities to market infrastructures and others to provide much needed support for credit creation. In the process, the patterns of risk bearing will be changed, and understanding this represents a challenge both to regulators but also to investors.”

And briefly:

And even more briefly:

For more information, see:

Canadian Regulators Announce Amendments to Regulations Governing Investment Funds:

CFTC Conducts Roundtable on Position Limits

FCA Pronounces How It Will Address Serious Failings in Firms That Don’t Meet its Conduct Standards:

IOSCO Publishes Results of Survey of Securities Markets Risk Trends:

Joint Audit Committee Provides Guidance on Financial Information FCMs Are Required to Make Publicly Available beginning July 12:

ICE Futures Consolidates Rules Related to Exemptions from Position Limits:

Korean Regulator Announces Plans to Further Develop Country’s Derivatives Markets
Access through:

LSE and DTCC Publish Report on Collateral Demand in the Evolving Marketplace:

NFA Proposes Amendments to Enhanced Supervisory Requirements:

SEC Charges Hedge Fund Manager With Retaliating Against Whistleblower and Engaging in Conflicted Transactions:

SEC to Host an Open Meeting on the Applicability of Security-Based Swap Dealer and Major Security-Based Swap Participant Definitions to Cross-Border Activities:

SEC Chair Calls for Fairer Fixed Income Markets:

SEC Sues House Committee and Employee to Compel Responses to Subpoenas Related to Insider Trading Probe:

US Senate Subcommittee Holds Hearing on High Frequency Trading:

See also press release announcing hearing:

Vision Financial Markets Barred as NFA Member:

See also: Resolution of In the Matter of Ace Investment Strategists and Yu Dee Chang:

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of June 21, 2014. No representation or warranty is made regarding the accuracy of any statement or information in this article. Also, the information in this article is not intended as a substitute for legal counsel, and is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The impact of the law for any particular situation depends on a variety of factors; therefore, readers of this article should not act upon any information in the article without seeking professional legal counsel. Katten Muchin Rosenman LLP and/or Gary DeWaal may represent one or more entities mentioned in this article. 

All quotations attributable to public speeches are from the prepared texts of the speaker.

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