The Division of Trading and Markets ("Division") has completed a limited-scope rule enforcement review of the self-regulatory programs of the Commodity Exchange, Inc. Division ("COMEX" or "Exchange") of the New York Mercantile Exchange ("NYMEX").1 The purpose of this review was to evaluate certain aspects of the Exchange's audit trail system for compliance with Regulation 1.35 and to evaluate the Exchange's trade practice surveillance and disciplinary programs for compliance with Sections 5a(a)(8) and 5a(b) of the Commodity Exchange Act ("Act") and Commission Regulation 1.51. This review was limited in scope because the Division recently evaluated the Exchange's audit trail, trade practice surveillance, and disciplinary programs as part of its review of the Exchange's petition for exemption from the dual trading prohibition contained in Section 4j(a) of the Act and Commission Regulation 155.5.2 The Commission granted the Exchange's petition by Order dated May 6, 1997.3 In granting the Order, the Commission concluded that the Exchange's floor surveillance, audit trail, recordkeeping, surveillance, and disciplinary programs satisfied the requisite standards set forth in the Act to detect and deter dual trading-related abuses.4 The Commission further found that the Exchange committed sufficient resources to be effective in detecting and deterring violations by, among other things, maintaining an adequate staff to investigate and to prosecute disciplinary actions.
This review covers the period of July 1, 1997 to June 30, 1998. The Division's previous rule enforcement review of the Exchange's compliance program was presented to the Commission on December 21, 1993 ("1993 Review"). Pursuant to Section 8e(a) of the Act, the Division conducts a rule enforcement review of each domestic exchange every two years, to the extent practicable. However, due to the merger of the Commodity Exchange, Inc. with the New York Mercantile Exchange, effective August 3, 1994, the Division delayed commencing this rule enforcement review to allow sufficient time for the two exchanges to merge their compliance staffs and programs into one Compliance Department. In addition, the Division determined not to conduct a rule enforcement review of the Exchange while the Commission was actively considering the Exchange's dual trading exemption petition since the Commission was thoroughly examining the Exchange's trade monitoring system in making its determination.
In the 1993 Review, the Division found that the Exchange had adequate trade practice surveillance and disciplinary programs, and recommended that the Exchange modify its contract size parameter or otherwise modify its computerized surveillance system to ensure that it could more consistently identify potentially violative trades. The Division also recommended that the Exchange consider past disciplinary history when imposing penalties and promptly prepare written decisions of its Appeals Panels. With regard to the Exchange's audit trail program, the Division recommended that the Exchange: (1) develop a program that compares member-recorded execution times for straddles to the Time and Sales Straddle Report and include these data in calculating the Exchange's one-minute trade timing accuracy rate and (2) take action to remind members of their responsibility to use a new trading card at the beginning of each new 30-minute trading interval. The last of these findings is implicated in the findings of this review.5
During an on-site visit to the Exchange, Division staff interviewed Compliance Department officials, including the Director of the Trade Practice Surveillance unit and the Exchange's Compliance Counsel. Division staff also reviewed Exchange documents that included, among others, the following:
- Computer reports and other documentation used routinely in the conduct of trade practice surveillance;
- All trade practice investigation and disciplinary action files for cases closed during the target period;
- Trade practice investigation and disciplinary action logs;
- Minutes of the meetings of the disciplinary committees held during the target period;
- Compliance manuals and guidelines; and
- Trading card and order ticket review logs.
The Division provided the Exchange with the opportunity to review and comment on a draft of this report on June 16, 1999. On June 24, 1999, Division staff conducted an exit conference with COMEX officials to discuss the report's findings and recommendations.
III. CURRENT FINDINGS AND RECOMMENDATIONS
A. Recordkeeping - Order Tickets and Trading Cards
- The Exchange maintains an adequate program for conducting order ticket reviews and Exchange members and firms generally have a high level of compliance with order ticket requirements.
- Exchange members are reviewed at least once a year for trading card recordkeeping compliance and the Exchange re-reviews members who fail any element of a trading card review. This resulted in the Exchange examining a large number of trading cards during the target period.
- The Exchange successfully integrates its recordkeeping reviews with its trade practice surveillance program. Investigation logs and investigation reports indicated that trading cards are routinely reviewed during trade practice investigations. However, a substantial number of investigation files did not include work papers documenting the review.
- Although members generally demonstrated a high level of compliance with a number of trading card recordkeeping requirements, member compliance fell below an acceptable level for several important recordkeeping standards, addressed below in the Division's recommendations.
- The Exchange should increase the required trading card compliance level from 85 percent to 90 percent, similar to its benchmark for order ticket compliance, and increase its summary fines for trading card violations. The Exchange also should issue a notice to members reminding them of their responsibility to: (1) use a new trading card at the beginning of each new 30-minute trading interval; (2) record the hour, as well as the minute, of all trades on a trading card; (3) identify trades executed during the opening and closing trading periods; and (4) submit trading cards to the Exchange or a clearing member within 15 minutes after the end of each half-hour trading interval.
- The Exchange should ensure that work papers documenting trading card reviews are included in investigation files when trading card reviews are performed during the course of a trade practice investigation.
B. Trade Practice Surveillance Program
- The Exchange maintains an adequate trade practice surveillance program primarily through the utilization of floor surveillance and automated surveillance.
- The Exchange's concerted effort to hire experienced staff resulted in the hiring of six investigative analysts who possess relevant industry and surveillance experience.
- Trade practice investigations were generally thorough, well analyzed, and adequately supported by documentation. The Exchange requires that closeout memoranda be written within three weeks of a closeout sign-off sheet. However, several closeout memoranda were written more than three weeks following the date of the closeout sign-off sheet.
- The investigations that were open longer than four months involved complex fact patterns and required numerous document requests. In addition, investigations often were expanded beyond their original scope.
- The Exchange should take action to ensure that investigation closeout memoranda are completed within three weeks of investigation closeout sheets.
C. Disciplinary Program
- COMEX generally maintains an adequate disciplinary program.
- Disciplinary matters are promptly referred to a disciplinary committee and findings appear to be supported by the evidence.
- In one instance, 17 months passed between the date when a complaint was issued and the date that a hearing was held and 13 months passed before a hearing decision was issued. The case was appealed and an appellate decision was not issued until four and one-half months following the appellate hearing.
- Fines totaling $115,000 and membership suspensions totaling 370 days were imposed against five members for trade practice violations. Although the penalties imposed appeared reasonable relative to the conduct being sanctioned and also appeared to take into account members' past disciplinary histories, the Exchange did not order restitution in cases in which customer harm was determined.
- Summary fines totaling $14,150 were imposed for trading card recordkeeping and trade timing violations.
- The Exchange should order restitution in all settlements and disciplinary decisions where the amount of customer harm can be determined.
- The Exchange should take action to ensure that Adjudication Committee hearings are held promptly after a complaint is issued and that Adjudication Committee and Appeals Committee decisions are issued in a more timely manner.
COMMISSION REGULATIONS 1.35 (a-1) (2)-(4) and 1.35(d)
Pursuant to Commission Regulation 1.35(a-1)(2), each exchange member or its designated person receiving a customer's order on the floor must prepare a written record of the order in non-erasable ink, including the account identification and order number. The member then must timestamp the order to reflect the date and time, to the nearest minute, that it is transmitted to or received on the exchange floor. When the execution price is reported from the floor, the order must be time-stamped again, pursuant to Regulation 1.35(a-1)(4). COMEX Rule 4.81 requires member compliance with these requirements.
Commission Regulation 1.35(d) requires that trading members record information for all transactions on trading cards or other records, including the member's name, opposite member's identification, clearing member's name, date, execution time, commodity, future, quantity, price and delivery month. Further, members recording purchases and sales on trading cards must record such purchases and sales in non-erasable ink, in exact chronological order of execution, on sequential lines of the trading card without skipping lines between trades, and must cross out any remaining lines on the trading card. Trades made during an exchange's opening and closing periods also must be separately identified.
In addition, Commission Regulation 1.35(d) requires that trading cards contain pre-printed identification information and sequence numbers to distinguish one member's cards from another's, to permit the sequencing of cards and to differentiate each card prepared by a member from such other cards for no less than a one-week period. Trading cards also must be collected by the exchange or the pertinent clearing member within 15 minutes of designated trading intervals not exceeding 30 minutes beginning with the opening of each trading session, and each member must use a new trading card at the beginning of each 30-minute interval. COMEX Rule 4.80 requires member compliance with these requirements.6
The COMEX trading card is a three-ply card. To comply with the collection requirement, the original top ply is deposited at a designated Exchange collection point and time-stamped by an Exchange representative. It is then routed to the appropriate primary clearing member ("pCM"), who is responsible for its retention.7 One of the two other copies is required to be maintained by the floor member.
The Exchange conducts a routine review of floor order tickets and a routine review of branch office order tickets to assess compliance with the aforementioned order ticket requirements. Separately, the Exchange evaluates members' compliance with trading card requirements by conducting routine reviews of trading cards, which the Exchange refers to as "audit trail reviews." The Division examined the results of the Exchange's order ticket and audit trail reviews completed during the target period, and conducted an independent review of floor order tickets and randomly selected samples of trading cards to assess member compliance with Exchange rules and Commission regulations.
In January 1997, the Exchange began conducting bimonthly, rather than quarterly, order ticket reviews. A Compliance Department supervisor or manager selects one broker group for review which results in the opening of a floor order ticket review and a subsequent branch office order ticket review. With respect to floor order ticket reviews, the Exchange requires that a minimum of 30 orders be reviewed from a day within the relevant month in which the selected broker group has significant trading volume. If the Exchange determines that the broker group has sufficient activity on a single day in a single commodity, then orders in that commodity for the selected day are the focus of the review. If a single day's business or the activity in a single commodity is insufficient to provide the minimum required sample, additional trade dates and/or commodities are selected.
A Compliance Department analyst examines each order for the required account identification information and timestamps.8 All filled or partially filled orders are required to have entry and exit timestamps, while unfilled or canceled orders are required to contain at least an entry timestamp. As an adjunct to the review, a sample of the filled orders also are matched to the corresponding trades on the executing broker's trading cards, which are requested as part of the order ticket review, to determine if the manually recorded trade execution time on the card is consistent with the order ticket's entry and exit timestamps.9
Upon the conclusion of the floor order ticket review, a branch order ticket review is initiated. The analyst, in consultation with a manager or supervisor, selects one group of order tickets for certain futures commission merchants ("FCMs") from the orders received from the broker group and requests corresponding branch orders. The analyst conducts a review similar to that performed for floor order tickets for between 10 and 15 of the branch order tickets. In addition, the analyst examines the timestamps on the branch orders in conjunction with trading card times and time and sales prints to ensure that they are chronologically consistent, and compares the branch order account identifier with the floor order account identifier to ensure that they are consistent. In April 1998, the Exchange increased the required floor and branch order ticket recordkeeping compliance level from 85 percent to 90 percent.
The Division's review of the Exchange's floor order ticket reviews completed during the target period revealed that the Exchange examined a total of 2,150 floor order tickets.10 The Exchange found that of the 2,150 order tickets examined, 2,078 (97 percent) reflected account identification and 2,023 (94 percent) contained appropriate timestamps. The Exchange completed four of the six bimonthly branch order ticket reviews opened during the target period and examined 45 branch order tickets, 44 (98 percent) of which reflected account identification and 41 (91 percent) of which contained appropriate timestamps.
In addition to reviewing the results of the Exchange's floor and branch order ticket reviews, Division staff independently reviewed the 102 floor order tickets that comprised the Exchange's January 1998 floor order ticket review and concurred with the Exchange's findings.11 Specifically, all of the 66 filled order tickets bore an account identifier and 60 (91 percent) of the filled order tickets contained appropriate timestamps. All of the unfilled orders also complied with the timestamping requirements, containing at least an entry time. However, nine of the 36 unfilled orders (25 percent) did not contain an account identifier. Exchange staff met with the responsible broker and the clearing firm to clarify the proper account identification procedures and issued warning letters.
B. Audit Trail Reviews
1. Exchange Procedures and Results
In addition to the bimonthly order ticket reviews, the Exchange conducts a monthly review of trading cards for member compliance with COMEX Rule 4.80. As noted above, the trading card review is called the audit trail review. To ensure that each member is examined at least once a year for trading card compliance, the Exchange organizes its trading population into 12 groups evenly distributed among its PCMs.12 Each month, the Exchange randomly selects 30-35 members from its PCMs to comprise a sample for an audit trail review. At least five more members are selected for review from the following computer reports: the Broker vs. Price Change Register Trade Time Comparison Report ("Broker vs. PCR Report"),13 the Broker vs. Broker Report,14 and the Broker On-Time Trade Summary Report.15 Those members with the highest noncompliance level are selected. In addition, in July 1997, the Exchange instituted a policy of re-reviewing all members who failed any element of a prior audit trail review.16
Within the group selected for an audit trail review, the Compliance Department reviews a subgroup for compliance with the collection requirement of COMEX Rule 4.80(g). Rule 4.80(g) requires that within 15-minutes after the end of each half-hour bracket, floor members submit the original top ply of each trading card used during the bracket to the members' PCM or deposit the card at a designated Exchange collection point.17 This subgroup includes all members selected for an audit trail review from the various computer reports, as described above. To test for collection timeliness, Compliance Department staff examines approximately 15 trading cards for each of the selected members to compare the timestamp on the back of a trading card to trade times manually recorded on the front of the trading card. The Exchange requires that each trading card be timestamped upon collection as evidence that the trading card is out of the broker's or trader's possession within the required time period.
In order to enforce compliance with all trading card recordkeeping requirements, the Exchange has implemented a summary disciplinary procedure administered by the Compliance Department. If the Compliance Department finds that a member has committed a trading card infraction, i.e., the member's compliance with any of the recordkeeping standards falls below 85 percent, a warning letter is issued. The member will be fined $100 for a subsequent infraction within a 12-month period, $500 for a subsequent infraction within an 18-month period, and will be referred to the Business Conduct Committee for another infraction within a 24-month period. For the reasons articulated below, this summary schedule may have to be more stringent in order to increase compliance with some trading card content requirements.
The Division's examination of the 13 audit trail reviews completed during the target period revealed that a large number of trading cards were examined. The Compliance Department reviewed a total of 15,331 trading cards, an average of 1,179 trading cards per month. These audit trail reviews included three reviews that were opened prior to the Exchange's new policy of re-examining those members who performed poorly in prior reviews. A comparison of audit trail reviews disclosed that the Exchange's new procedure resulted in a significant increase in the number of members selected for review each month and the number of trading cards examined.
Specifically, for the three audit trail reviews conducted pursuant to the old procedure, the number of members selected for review was approximately 40 and the number of trading cards examined per review ranged from 386 to 515. In comparison, for the ten audit trail reviews that included the re-review of selected members, the number of members selected for review ranged from 34 to 56 and the number of trading cards examined per review ranged from 1,111 to 1,689.18
2. Integration of Recordkeeping and Trade Practice Surveillance
The Division found that COMEX successfully integrates its order ticket and trading card reviews with its trade practice surveillance program. If suspicious trading activity is identified, the review is expanded to investigate potential substantive trading violations. Trading cards are also routinely examined during the course of trade practice investigations.19 During its examination of investigation files, the Division was able to confirm from either investigation logs or investigation reports that Compliance staff routinely review trading cards during trade practice investigations.20 However, the Division could not review the details of these trading card reviews because a substantial number of investigation files did not include work papers documenting the review.
Compliance Department staff also are given a list each month of members whose trading cards will be examined during the next scheduled audit trail review. This apprises staff that may currently be reviewing the activity of a particular member for substantive trading violations of the opportunity to look at additional source documents for that member. These source documents may be relevant to the particular facts of the ongoing investigation or may assist in establishing a pattern of illegal activity. This practice contributed to a successful investigation that resulted in the Exchange fining two members.21
3. Division's Independent Trading Card Review
To independently assess member compliance with trading card recordkeeping requirements, Division staff examined 830 trading cards submitted by 20 of the 43 floor members that were part of the Exchange's June 1998 audit trail review. Division staff found that all 830 cards contained the members' names or codes and reflected all entries in non-erasable ink. Of the 830 trading cards, 773 (93 percent) contained the transaction dates. In addition, 820 trading cards (99 percent) were used in sequence and, based on a review of the manually recorded execution times, 95 percent of the trades on the 830 trading cards were recorded sequentially. No lines were skipped between trades on any of the trading cards examined and 789 cards (97 percent) met the requirement that the remaining lines on the trading card be marked through following the last recorded execution. Of the 830 trading cards, 802 (97 percent) indicated the opposite broker, 792 (95 percent) indicated the underlying commodity traded, 807 (97 percent) indicated the contract month, 824 (99 percent) indicated the quantity traded, and 810 (98 percent) indicated trade price.
However, the Division found that there was an unacceptable level of compliance with respect to several important recordkeeping standards. For example, there were 104 trading cards on which more than one bracket was recorded, indicating an 84 percent compliance rate with the requirement that a new trading card be used at the beginning of each designated 30-minute interval.22 In addition, with respect to COMEX Rule 4.80(b)(E), which requires that each trade entry shall clearly and accurately record the time of execution of the trade to the nearest minute, the 20 members whose trading cards were examined had an overall compliance level of 82 percent. In large part, this compliance rate results from members recording only the minute, and not the hour, of execution.
COMEX trading cards contain a box at the top of each card for members to record the hour of the trades recorded on the trading card.23 The Division, unlike the Compliance Department, will not consider a trade execution time as clear and accurate if the trading card failed to reflect the hour of execution. The Exchange, on the other hand, will consider a trade time as clear and accurate, even if a trading card does not include the hour of trades, if the hour of a trade is ascertainable from other documents that are available to Exchange staff during an audit trail review. The Division does not believe that this satisfies the requirement that members clearly and accurately record the execution time of each trade on a trading card. Accordingly, the Division recommends that the Exchange require that members record, on the space provided on the trading card, the hour of all trades recorded on the card. This would result in a complete, unambiguous time of execution and would not be an onerous burden on members.
The Division further found that trades executed during the opening and closing trading periods were so indicated 84 percent and 81 percent of the time, respectively. Finally, the Division's examination disclosed that 30 percent of the trading cards examined were not timely submitted to a clearing member. Specifically, 570 trading cards (70 percent) of the 830 examined were submitted to a clearing member within 15 minutes after the end of each half-hour bracket as required under COMEX Rule 4.80(g).
C. Conclusions and Recommendations
The Division found that the Exchange maintains an adequate program for conducting order ticket reviews. Floor order ticket and branch order ticket reviews are conducted bimonthly. Based on the Exchange's floor order ticket and branch order ticket reviews, and the Division's independent review of floor order tickets, the Division found that Exchange members and firms generally have a high level of compliance with order ticket content requirements.
With respect to monthly audit trail reviews, the Exchange has implemented procedures to ensure that each member is reviewed at least once a year for trading card recordkeeping compliance. This resulted in the Exchange examining a large number of trading cards during the target period. In addition, the Exchange's policy of re-reviewing members who fail any element of an audit trail review has significantly increased the number of members selected for review each month and the number of trading cards examined.
The Division also found that COMEX successfully integrates its recordkeeping reviews with its trade practice surveillance program. The Division was able to confirm from detailed investigation logs and investigation reports that trading cards are routinely examined during the course of trade practice investigations. However, a substantial number of investigation files which indicated that member(s) trading cards had been examined during a trade practice investigation did not include work papers documenting these trading card reviews. Thus, the Division could not examine the details of these reviews.
The Division's independent examination of 830 trading cards belonging to 20 members disclosed that while members generally demonstrated a high level of compliance with a number of trading card recordkeeping requirements, the Exchange must take action to improve member compliance with several important recordkeeping standards. First, the Division's review disclosed that 30 percent of the trading cards were not submitted to a clearing member within 15-minutes after the end of each half-hour bracket, as required under COMEX Rule 4.80(g); second, a large number of trading cards reflected only the minute of trades recorded on a trading card, not the hour, despite the Exchange's requirement that a clear and accurate execution time be recorded for each trade; and third, trades executed during the opening and closing trading periods were only indicated as such 84 percent and 81 percent of the time, respectively. The Division also found that 16 percent of the trading cards it examined did not satisfy the requirement that a new trading card be used at the beginning of each designated 30-minute interval. This deficiency also was identified during the 1993 Review.
Based on these findings, the Division believes that the Exchange should consider ways to improve members' compliance with certain trading card recordkeeping requirements. In doing so, the Exchange should consider, among other things, increasing the required compliance level to 90 percent. This would be consistent with the Exchange's practice regarding order ticket compliance. The Exchange also should consider increasing its fining schedule for trading card violations.
Based on its review, the Division recommends that the Exchange:
- Increase the required trading card compliance level from 85 percent to 90 percent, similar to its benchmark for order ticket compliance, and increase its summary fines for trading card violations. The Exchange also should issue a notice to members reminding them of their responsibility to: (1) use a new trading card at the beginning of each new 30-minute trading interval; (2) record the hour, as well as the minute, of all trades on a trading card; (3) identify trades executed during the opening and closing trading periods; and (4) submit trading cards to the Exchange or a PCM within 15 minutes after the end of each half-hour trading interval.
- Ensure that work papers documenting trading card reviews are included in investigation files when trading card reviews are performed during the course of a trade practice investigation.
V. TRADE PRACTICE SURVEILLANCE - SECTION 5a(8) AND 5a(b) AND
COMMISSION REGULATIONS 1.51(1), (2), (4), (5) AND (6)
Section 5a(a)(8) of the Act requires each exchange to enforce the bylaws, rules, regulations, and resolutions made or issued by it, the governing board or any committee. Section 5a(b) of the Act requires each exchange to maintain and to use a system to monitor trading to detect and deter violations of the exchange's rules committed in the making of trades. Under Section 5a(b)(1), such a system must include, among other things, trade practice surveillance systems capable of reviewing, and used to review, trade data in order to detect violations committed in making trades and executing customer orders; floor surveillance; and the commitment of resources necessary for a trade monitoring system to be effective in detecting and deterring trade practice violations, including adequate staff to develop and prosecute disciplinary actions.
In addition, Commission Regulation 1.51 has long required that each exchange exercise due diligence in maintaining a continuing program for the surveillance of trading practices on the floor of the exchange; for the investigation of customer complaints and other alleged or apparent violations of the exchange bylaws, rules, regulations and resolutions; and for such other surveillance, record examination, and investigation as is necessary to enforce exchange bylaws, rules, regulations, and resolutions.
As part of the merger of COMEX and NYMEX, the self-regulatory staffs of the two exchanges were merged into one Compliance Department which is divided into three sections: Trade Practice Surveillance, Market Surveillance, and Financial Surveillance. The Compliance Department is led by the Vice President of Compliance, who has served in this position since the NYMEX/COMEX merger in August 1994. Prior to the merger, the Vice President served as Vice President of Compliance at NYMEX. The Trade Practice Surveillance unit consists of 21 persons, including a Director.24 The Director has ten years of trading floor experience, including eight years as a COMEX member. Prior to being appointed Director in October 1996, he served as a Compliance Department supervisor. The Director has overall responsibility for the investigation and prosecution of rule violations. The Trade Practice Surveillance unit is supported by one Compliance Counsel and two Associate Counsels. The Compliance Counsel, who has been with COMEX for almost ten years, oversees the legal aspects of all trade practice investigations and coordinates all phases of the Exchange's disciplinary proceedings. The Vice President, the Compliance Counsel, and the Director ultimately determine whether evidence supports the Compliance Department recommending that an investigation be referred to a disciplinary committee.
The Compliance Department's Trade Practice Surveillance staff also includes one supervisor, four managers, eleven analysts, and three clerks. The supervisor and managers, who report to the Director, oversee investigations and provide general guidance to the analysts and clerks. They also contribute to the process of determining whether an investigation should be referred to a disciplinary committee. Analysts are responsible for reviewing computerized reports, including the Exchange's trade register, conducting floor surveillance and order ticket and audit trail reviews, and investigating potential violations detected from the review of computerized reports or which are referred by other sources, such as customers, members, and the Commission. The clerks perform administrative functions and conduct certain audit trail review procedures.
During the first half of 1998, the Exchange identified a pattern of high employee turnover in which the Exchange hired entry level staff, invested a great deal of time in training them as analysts, and then many would leave after two or three years. To remedy this situation, the Exchange began a concerted effort to hire experienced employees for its Trade Practice Surveillance staff. As part of this effort, six analysts were hired in 1998 who possessed demonstrated industry knowledge, surveillance experience, or other relevant experience, and an interest in enforcement and regulation.25 For example, four of the newly hired analysts possessed past trading floor and surveillance experience and two had a law enforcement/criminal justice background. Of the four analysts with trading floor and surveillance experience, one has 20 years of experience in the futures industry, including 14 years of trading floor experience; one has 11 years of floor trading experience; one has five years prior experience as a National Association of Securities Dealers examiner; and one has ten years of surveillance experience with the Chicago Mercantile Exchange.
B. Automated Trade Practice Surveillance
The Exchange's trade practice surveillance program relies upon several automated reports including the Daily Brokerage Recap ("DBR"), the Exchange's trade register; exception reports generated by the Exchange's automated trade practice surveillance system, the Trade Surveillance Exception Reporting System ("TSER"); and specialized surveillance reports. All of these reports and the PCR are available to Compliance Department staff on-line through the Exchange's COMSTAR system. The COMSTAR system, implemented in 1996, allows analysts to view all pertinent surveillance reports on their desktop computers and to sort the data in spreadsheets. This ability to view and sort data on-line enhances the volume of trade information that can be reviewed. All of the automated reports also are available in hard copy.
1. Daily Brokerage Recap
The DBR contains each matched and unmatched trade and reflects the executing broker, clearing member, trade date, contract, month, quantity, price, opposite member and clearing member, account number, minute of execution, CTI code for each side of a trade, trade identification number, strike price, put or call, and premium.26 The DBR sorts trading data in two ways: (1) by executing broker and clearing member and (2) by executing broker and time of execution.
Analysts review the DBR on one randomly selected day each week and on particularly volatile days. The review covers all trading activity for the entire day. The Exchange maintains a log of the weekly DBR reviews which includes the review date, analyst, supervisor or manager, trade date, and any comments. The Division reviewed sample pages from the DBR log and found that the reviews were conducted as scheduled. During the target period, four investigations were initiated based on a DBR review. Three of these investigations involved possible prearranged or noncompetitive trading and the other investigation concerned possible fictitious trading.
2. Exception Reports
The Exchange's automated trade practice surveillance system, TSER, generates several daily reports designed to isolate suspicious trading activity. TSER reports are generated from data contained in the DBR with selection parameters adapted for each specific category of potential violation. These parameters can be modified by Compliance Department staff, as necessary. The Exchange uses these reports to identify possible instances of trading ahead, withholding orders, disclosing orders, accommodation trading, prearranged trading, improper cross trading and money passing schemes. The reports also are used to expand the scope of an investigation where potential violative trading patterns may have been found.
The Trading Ahead Report reflects trades where the executing broker trades for his or her own account, or an account that he or she controls, and the broker's trade is on the same side of the market within five minutes, before or after the customer's trade, and at an equal or better price than that received by the customer. The Preferential Trading Report is a TSER report designed to detect instances in which a member may be withholding customer orders from the market or disclosing the terms of orders for the benefit of another member. The system searches for any trades where the executing broker executes a customer trade opposite another member's personal trade. It then sorts the opposite member's trades for instances where such member's trades were on the same side of the market as the customer order, within five minutes before or after the customer trade, and at an equal or better price than that received by the customer.
The Prearranged Trading Report, another TSER report, is designed to detect three potential types of prearranged trading. First, the report identifies possible violations involving a single customer order where the executing broker may have traded indirectly opposite the order through the accommodation of another member. Second, the report identifies possible violations involving two customer orders and an accommodating member. Third, the report identifies possible violations involving three members. In the latter instance, the system selects instances where a broker traded indirectly opposite a customer order through the accommodation of two other members, i.e., where the third member trades for his or her personal account with both brokers, executing a wash trade to accommodate the other brokers.
The TSER system also generates the Payback Report, which is designed to detect members' potential prearranged trading intended to facilitate a money pass between members. The report reflects trades between the same executing and opposite brokers who, on the same day, trade at different prices for their personal accounts so that money passes between them. Finally, the TSER system produces a summary report, Total of Members' Appearances on Exception Reports Over Previous Two Months ("Summary Report"), that identifies members and their frequency of appearances on other TSER reports during the previous two-month period.
All of the TSER reports, with the exception of the Summary Report, are reviewed by analysts daily. The Summary Report is reviewed on an as needed basis. While each TSER report is generally assigned to the same analyst for daily review, assignments are rotated periodically so that each analyst becomes proficient in reviewing all of the exception reports. Analysts review their assigned exception report and record any findings on the relevant exception log.27 The analyst generally looks for a pattern indicative of illegal trading activity, the frequency of a member's appearances on the exception reports, and the size of the trades. In addition, analysts attempt to identify suspicious trades for follow-up review, even if such trades are not part of a pattern of suspicious trading activity. Analysts also may review exchange records relating to a particular suspicious trade. If an analyst determines to request underlying trading documents, an investigation is opened. During the target period, 36 investigations were opened based on Exchange review of various TSER reports, as detailed below.
3. Specialized Computer Reports
Exchange staff also review three specialized computer-generated reports which detail certain activity. These reports are not designed as exception reports. The first of the reports is the Crossed Trades Report, which is reviewed by a Compliance Department analyst weekly to detect possible violations of the Exchange's prohibition against members crossing their customer orders against their personal accounts. One investigation was initiated from this report during the target period. The other two specialized reports, the Broker Unmatched Trade Report and the Correction Audit Trail Report, are reviewed by the Exchange's Trade Audits Department.28
C. Floor Surveillance
Trade practice analysts routinely observe trading at the open, the close, and at one random time during the trading day. At the beginning of each month, a schedule is prepared showing analysts assignments. One analyst is assigned to cover the opening trading period from 8:00 a.m. to 8:40 a.m. This same analyst, along with all other available analysts, observes the closing trading period from 1:50 p.m. until the end of the post-settlement close of the gold market, sometime after 2:30 p.m. The Compliance Department also assigns an analyst to observe trading activity for approximately 20 minutes during the trading day. All analysts are encouraged to observe the trading floor at random times during the trading day, especially during busy periods. In addition, the Exchange increases floor surveillance when warranted by extraordinary market conditions.29
If an analyst observes an apparent trading violation while on the floor, he or she is required to document immediately their observations in writing, initial the notes, and, if possible, promptly timestamp the notes at a time clock on the trading floor. All analysts also are required to fill out a Weekly Floor Observation Sheet detailing their weekly floor surveillance activities. The analysts indicate for each trading day the time they were present on the floor, the market(s) observed, and observations.30 Analysts also discuss any unusual observations with the Compliance Department supervisor, a manager, or Compliance Counsel to determine if further action should be taken.
The Exchange uses floor surveillance observations to: (1) detect violative transactions, including noncompetitive trading and improper cross trading; (2) determine the physical location of members relative to other members; (3) determine members' affiliations with other members; (4) document various floor trading practices; (5) identify trading patterns that are unusual for particular members; and (6) deter members from engaging in illegal trading activity, including noncompetitive trading and trading before the open or after the close. Additionally, floor surveillance provides the floor population an opportunity to interact with Compliance Department staff on occasions when Exchange rules may need clarification. One investigation was initiated during the target period as a result of floor surveillance. Based on floor observations, Compliance Department staff questioned whether a suspended member, who was permitted to act in a clerical capacity for his brokerage company, was actually trading for his own account. A follow-up investigation found that the member was not trading for his personal account.
D. Adequacy and Timeliness of Investigations
1. Adequacy of Investigations
The Compliance Department initiates and conducts investigations when information obtained indicates that a possible violation of Exchange or Commission rules may have occurred. That information may be derived from floor surveillance, reviews of TSER and DBR reports, or from external sources that include member, customer, and anonymous complaints. Investigations also may be initiated as a result of referrals from the Commission or the National Futures Association ("NFA"). Once a decision has been made to open an investigation, an analyst and investigation number are assigned to the matter and it is recorded into an investigation log maintained by the Compliance Department. The Exchange's investigation log includes, for each investigation, the date it was opened, the member being investigated, the nature of the investigation, and the initials of the analyst assigned to the investigation. Each month the Exchange prepares a document entitled "COMEX Division Open Case List" which includes, among other information, investigations opened during the current month, and investigations that have been ongoing for two to four months or more.31
At the initiation of an investigation, the analyst will request documentation from the members involved by sending a form letter, which is either hand delivered or accepted in the Compliance Department by the addressee or his/her designee. In either instance, the recipient signs a copy of the letter to acknowledge receipt. A signed timestamped copy is kept in the investigation file. Upon receipt of the requested documentation, the analyst reviews the documents along with other records, including relevant PCRs and DBRs. While an alleged violation may determine the direction and general scope of an investigation, an investigation may be expanded to include other potential violations that become evident during the course of the general investigation.
During the target period, Compliance opened a total of 59 investigations. Of these, 46 were internally generated by the Compliance Department, including 29 (63 percent) through review of the Prearranged Trading Exception Reports; six (13 percent) through review of the Trading Ahead Exception Reports; one (two percent) through review of the Preferential Trading Exception Reports; and four (nine percent) through review of Daily Brokerage Recaps. Six (13 percent) additional investigations were developed by the Compliance Department based on reviews of order ticket, trading card, cross-trade, correction slip, and out-trade correction procedures. Of the remaining 13 investigations, six were opened based on customer complaints; four were initiated because of member complaints and/or referrals; one was opened due to an observation made on the trading floor; one (8 percent) was initiated due to a member's appeal of floor fines; and one (8 percent) was based upon a Division referral concerning possible trading ahead of customer orders.32
The Division reviewed all 58 of the Exchange's trade practice investigations that were closed during the target period, including two Division referrals. The investigations reviewed included, among others, investigations of possible trading ahead, prearranged trading, and other non-competitive trading, as well as customer complaints.
The Division found that Exchange staff generally conducted appropriate analyses and that investigations were thorough and well documented. Investigation files contained relevant documentation, including copies of trading cards, order tickets, computerized exception reports, DBRs, PCRs, and correspondence. When interviews were conducted as part of an investigation, the interview date was recorded in the investigative file. Tape recordings of interviews are generally not included in investigation files, but are maintained within the Compliance Department.
The Exchange considers an investigation closed as of the date a discussion takes place between the Director, the analyst that worked on the case and, in most instances, the supervisor or manager who supervised the investigative process. Simultaneous with a determination that a case be closed, a "closeout sign-off sheet" is prepared by the analyst and signed by the Director. Investigative files examined by Division staff revealed that the closeout sign-off sheets contained relevant information concerning the disposition of the case, as well as pertinent facts. The rationale behind the decision to close an investigation with no action, to issue a warning letter, or to refer the matter to a disciplinary committee also is included. The subject(s) of the investigation are notified of the determination in writing within 48 hours of the closeout sign-off sheet's completion. Likewise, in the case of a customer initiated investigation, the complainant is notified within the same period of time. At this point the investigation is completed and no further analysis takes place.
The analyst then prepares a "closeout memorandum" describing the details of the investigation, including how it was initiated, the facts developed during the course of the investigation, and the staff's conclusions and recommendations. During December 1997, the Compliance Department implemented a policy requiring that a closeout memorandum be completed within three weeks of the closeout sign-off sheet.33 However, the Division's review of investigations closed after this policy was implemented disclosed that closeout memoranda are often written more than three weeks following the date of the closeout sign-off sheet. The Division found 16 instances in which closeout memoranda were written anywhere from one month to 15-months following a closeout sign-off sheet.34 These memoranda should be completed and available in a much more timely fashion.
2. Timeliness of Investigations
The Division found that the Exchange's investigations were generally completed in a timely manner. Of the 58 trade practice investigations closed during the target period, including 25 opened prior to the start of the period, 21 (36 percent) were completed in four months or less. Another 17 (29 percent) were closed within four to six months, and 20 (34 percent) were closed within six months to one year. Of the 33 investigations opened and closed during the target period, 16 (48 percent) were completed within four months, seven (21 percent) were closed between four and six months, and 10 (30 percent) were closed within six months and one year. At the beginning of the target period, 27 investigations were open. By the close of the target period, 25 of these investigations were closed, including three that were referred to a disciplinary committee. Of these 25 closed investigations, five (20 percent) were completed within four months, 10 (40 percent) were closed between four and six months, and 10 (40 percent) were closed between six months and one year.
As indicated, with the exception of two investigations, there were no investigations open beyond one year.35 Those investigations that were open between six months and one year were justifiably open for that length of time. These investigations involved complex fact patterns, required numerous document requests and interviews, and several were expanded beyond their original scope. For example, Investigation No. 03-924-100196, which was open just under 12 months, initially involved potential pre-arranged and non-competitive trading among three members. The investigation was later expanded to include two more members. Documents were requested from all five members' PCMs. As part of the investigation, the Compliance Department reviewed trading activity covering six months and numerous trading cards, order tickets, DBRs, PCRs, pit slips, and Time and Sales Straddle Reports. In addition, all five members and an Exchange floor representative were interviewed. Compliance Department staff also had discussions with several PCMs. The Exchange found no indication of additional violations. Ultimately, three members received warning letters.
Twenty-six investigations opened during the target period remained open at the end of the target period. Of these, 14 had been open for less than four months, seven had been open between four and six months, and five had been open for more than six months.
During the target period, the Exchange initiated six investigations based upon customer complaints and completed all of them by the close of the target period. Four of the customer complaints involved alleged bad fills and two involved settlement price disputes. Five of the customer complaints were closed in less than four months, and one was closed in just over four months. The Division found that the investigations of these customer complaints were timely, thorough, and well documented.
E. Conclusions and Recommendations
The Exchange maintains an adequate trade practice surveillance program through the utilization of floor surveillance and automated surveillance. The Exchange's effort to hire experienced staff resulted in the hiring of six analysts during 1998 who possess relevant industry and surveillance experience. The Division found that trade practice investigations were thorough, well analyzed, and adequately supported by documentation. Each investigative file contained, among other records, trading cards, order tickets, PCRs, DBRs, copies of correspondence, a listing in chronological order of requests for documentation and scheduling of interviews, an investigation closeout sign-off sheet, warning letters, and a closeout memorandum. The Exchange requires that a closeout memorandum be prepared within three weeks of a closeout sign-off sheet. However, the Division discovered several instances when the gap between these processes exceeded three weeks and has ranged from one-month to 15-months.
Although several investigations remained open up to a year, the Division found that these investigations involved complex factual patterns and required numerous document requests and interviews. Nevertheless, the Division believes that the Exchange should continue to strive to improve the timeliness of its investigations.
Based on its review, the Division recommends that the Exchange :
- Take action to ensure that investigation closeout memoranda are completed within three weeks of investigation close-out sheets.
VI. DISCIPLINARY ACTIONS - SECTION 5a(b) AND COMMISSION
Under Section 5a(b) of the Act, an exchange's trade monitoring system must include appropriate disciplinary actions and meaningful penalties against violators. In addition, Commission Regulation 1.51(a)(7) requires that each exchange use due diligence in maintaining a continuing affirmative action program which results in prompt, effective disciplinary action for violations of exchange rules. When reviewing disciplinary programs, the Division considers, among other factors, the support for findings made in disciplinary actions, the adequacy of sanctions imposed, and the timeliness of the procedures.36 The Division also assesses compliance with Commission Regulations 8.09 and 8.17, which require, respectively, that disciplinary committees review investigation reports in a timely manner and issue either a notice of charges or a written decision stating the reasons why no further action will be taken and that hearings be convened promptly after reasonable notice.
COMEX and NYMEX members and member firms are subject to the same disciplinary rules, hereinafter referred to as "Disciplinary Rules." As described below, the Business Conduct Committee ("BCC") and the Adjudication committees are divided into COMEX panels and NYMEX panels. For purposes of the Division's discussion and analysis, unless otherwise noted, all references to a committee or panel are to a COMEX committee or panel.
B. COMEX Disciplinary Committees
COMEX has three primary disciplinary committees: the BCC, the Adjudication Committee, and the Appeals Committee. In addition, Disciplinary Rules 8.21 and 8.22 authorize the Exchange's Floor Committee to impose summary fines, not exceeding $5,000, for violations of Exchange rules concerning matters such as clerk registration, decorum, practices disruptive of or inconsistent with orderly trading procedures, and the timely submission of accurate report records or similar matters for clearing or for verifying each day's transactions. The Floor Committee also is responsible for issuing warning letters and imposing and collecting fines with respect to the Exchange's recordkeeping summary disciplinary program administered by the Compliance Department.37
The BCC is divided into a COMEX Panel and a NYMEX Panel. The COMEX Panel consists of a Chairman, who is a NYMEX Division member, nine regular committee members, and four alternates.38 The BCC is responsible for determining whether a member or member firm should be prosecuted for violations of Exchange or Commission rules. As described below, the BCC also is authorized to enter into settlement agreements in conjunction with the initiation of disciplinary proceedings.
The Adjudication Committee is equally divided into four hearing panels, two COMEX Hearing Panels and two NYMEX Hearing Panels. The Adjudication Committee is chaired by a NYMEX member who is responsible for, among other things, appointing ten regular committee members for each Hearing Panel and designating alternates.39 The Hearing Panels conduct hearings, determine whether rule violations have occurred, and levy sanctions for any violations found to have been committed. The Hearing Panels also can enter into settlement agreements with respondents. Appeals from a Hearing Panel decision are heard by the Appeals Committee, whose members are selected by the Appeals Committee Chairman. In the event of an appeal, the Chairman appoints an Appeals Panel of three committee members, one of whom must be a COMEX member.40
All members selected to serve on an Exchange disciplinary committee must be approved by the Board of Directors ("Board"). With respect to conflict of interests, no person may serve in any of these capacities regarding a specific matter if that person has any direct financial, personal, or other interest in the matter under consideration. In addition, any person who has participated in any prior stage of the disciplinary process is not eligible to serve in a higher decisional capacity for the same proceeding. Furthermore, any person who, within the prior three years, has been found to or entered into a settlement agreement finding that he or she committed a disqualifying disciplinary offense, is prohibited from serving on any of the bodies involved in the disciplinary process.41
C. Disciplinary Procedures
If the Compliance Department determines that there is a reasonable basis to believe that a rule violation has occurred, an investigation report is prepared and delivered to the BCC. The investigation report includes the reasons that an investigation was initiated, the relevant facts, and the Compliance Department's conclusions and recommendations. At anytime prior to the submission of an investigation report to the BCC, the Compliance Department may negotiate a settlement offer. An individual or firm may agree, without admitting or denying a violation, to a settlement agreement that provides for any combination of the following sanctions: a cease and desist order, a censure, or a fine not exceeding $5,000 for each rule violation alleged. Any such settlement agreement is subject to BCC approval.42
If no such settlement agreement is reached, a copy of the investigation report is furnished to the individual or firm that is the subject of the report. The subject then has five days following receipt to submit a written statement and supporting documentation to the BCC for consideration.43 The BCC meets monthly to review investigation reports and related matters. Although individuals and firm representatives are permitted to appear and make oral presentations before the BCC, the presentation is limited to matters raised in the subject's written response to the investigation report.44 If the BCC concludes that a reasonable basis exists for finding that a rule violation has occurred, the BCC will take any one of the following actions: (1) return the matter to the Compliance Department for further investigation; (2) issue a warning letter; or (3) direct the Compliance Department to issue a complaint.45 The BCC also may consider settlement offers concurrent with or subsequent to consideration of an investigation report and may enter into such an agreement that could provide for any combination of the following sanctions: a cease and desist order, a censure, a fine not exceeding $25,000 per rule violation, a suspension not exceeding three months per rule violation, or expulsion.46
When the Compliance Department issues a complaint, it is delivered to the "respondent,"47 filed with the Exchange's Hearing Registrar, and forwarded to the Adjudication Committee, along with any written response and/or request for a hearing from the respondent, and any written reply from the Compliance Department.48 The Chairman of the Adjudication Committee assigns the case to one of the two COMEX Hearing Panels to hear and decide the matter. The Hearing Panels also may consider settlement offers, which are directed to the opposite COMEX Hearing Panel for consideration, and which, if approved, are subject to approval of the Board. The types of sanctions to which a COMEX Hearing Panel may agree as a result of a settlement agreement are similar to those which may be agreed to by the BCC, except that fines may be larger (with a ceiling of $250,000 per violation) and there is no three-month limit on the length of a suspension.49
If the respondent admits or fails to deny any rule violation charged in the complaint, the originally assigned Hearing Panel must impose a penalty for each violation and so notify the respondent within 45 days after receipt of the admission or failure to deny. If the respondent has submitted an answer denying the rule violations charged, and has not requested or has waived a hearing, the Hearing Panel must make its decision based on documents filed by the Compliance Department and the respondent, and render a written decision in the same manner as if a hearing had been conducted.50
In the event that a disciplinary matter proceeds to a hearing, the Hearing Panel generally must render a written decision within 45 days after the close of the hearing or the last day on which any post-hearing memoranda were required to be filed. If the respondent is found not to have committed any violation, the written decision must include a summary of the charges and the answer, a summary of the evidence produced at the hearing, and a statement of the findings and conclusions of the Hearing Panel with respect to each charge. If the respondent is found to have committed a violation, the written decision also must include an order stating the penalties imposed and the effective date of such penalties. The sanctions that may be imposed by a Hearing Panel in rendering a written decision are the same as those which may be included in a Hearing Panel settlement agreement, as described above.51 Unless appealed within 10 days, the Hearing Panel's decision is the final decision of the Exchange and is effective 15 days after delivery to the respondent and the Commission.52
In the event of an appeal, the Appeals Committee Chairman appoints an Appeals Panel to hear and decide the matter. The Appeals Panel may require the parties to make an oral presentation or may decide the appeal on the basis of the written submissions of the parties and the existing record of the proceeding. The Appeals Panel may affirm, reverse, or modify the Hearing Panel's decision, but may not set aside the Hearing Panel's findings of rule violations if those findings are supported by the record. The Appeal Panel's written decision must include, among other things, a statement of findings and conclusions regarding each charge or penalty reviewed. The Appeals Panel's conclusion constitutes a final decision of the Exchange and takes effect 15 days after delivery to the respondent and to the Commission.53
D. Sanctions Imposed
The Division reviewed the Exchange's Disciplinary Register, various disciplinary committee minutes, the Regulation 9.11 disciplinary action notices received from the Exchange reflecting disciplinary actions taken during the target period, and all related Exchange disciplinary files.54 During the target period, each of the five members referred to the BCC were sanctioned for various trade practice and recordkeeping violations.55 Generally, the penalties were the result of settlement agreements. However, one case resulted from a decision of an Adjudication Committee Hearing Panel and was affirmed by the Appeals Committee during the target period.56 The penalties imposed included substantial fines totaling $115,000, membership suspensions totaling 370 days, and four cease and desist orders.
Specifically, in the Adjudication Committee Hearing Panel decision upheld by the Appeals Committee, a member was fined $100,000, permanently prohibited from executing customer orders, and suspended for one year for engaging in a pattern of misconduct that included prearranged and noncompetitive trading, fraudulently executing customer orders, and various recordkeeping violations.57 In another case, one member was fined $10,000, ordered to cease and desist from engaging in noncompetitive and prearranged trading and indirectly taking the opposite side of customer orders, and was suspended for five days. The other member involved in this matter was permitted to withdraw from membership. However, the Exchange ordered that if the member reapplies for membership, he must pay a $5,000 fine prior to submitting a membership application. Neither member was ordered to pay restitution, despite the fact that customer loss was determined by the Exchange to be approximately $3,175.58 The Division believes that the sanctions in these two cases adequately reflected that two of the members had previous disciplinary histories involving prearranged trading.59 Finally, in another case, the Exchange fined two members, who were not previous offenders, $2,500 each and ordered both to cease and desist from engaging in noncompetitive and prearranged trading. Although the Exchange determined that customer loss was at least $1,350, the brokers were not ordered to pay restitution.60The Division generally found that the sanctions imposed during the target period were appropriate in relation to the rule violations committed and that the sanctions adequately reflected members' prior disciplinary records. However, the Division strongly believes that in those cases where the Exchange can determine customer loss, as it did in the above two cases, the Exchange should order respondents to pay restitution to injured customers.
During the target period, the Exchange also issued a total of 121 warning letters and imposed 36 summary disciplinary fines ranging from $100 to $1,000 for trading card and trade timing violations. In this regard, the Exchange issued 72 warning letters and imposed 25 summary fines totaling $2,900 for various trading card recordkeeping violations. The Exchange also summarily warns and fines members each month whose audit trail accuracy rate falls below 80 percent. Under this program, the Exchange issued 49 warning letters and imposed 11 summary fines totaling $11,250.
E. Timeliness of Disciplinary Proceedings
Commission Regulation 8.09 requires that an exchange disciplinary committee promptly review each investigation report and, if the committee determines that additional investigation or evidence is needed, promptly direct the Compliance staff to conduct further investigation. Within 30 days of receiving a completed investigation report, an exchange disciplinary committee must either (1) determine that no reasonable basis exists for finding a violation or that prosecution is unwarranted and direct that no further action be taken or (2) determine that a reasonable basis exists for finding a violation which should be adjudicated and direct that the alleged violator be served with a notice of charges.61 Regulation 8.09 further provides that if a disciplinary committee determines that no reasonable basis exists for finding a violation and directs that no further action be taken, such determination "must be in writing and contain a brief statement setting forth the reasons therefor."
During the target period, the BCC reviewed three investigation reports involving four members. In each instance, the BCC determined during the respective meeting, that a reasonable basis existed to issue a complaint. Thus, the BCC's determinations all were within the prescribed 30-day time period. The Division also reviewed the length of time between the date of BCC decisions to issue charges and the dates complaints were served, the length of time between the date that complaints were issued and the date of a hearing, and the length of time from the conclusion of a hearing until the issuance of a written decision. The Division found that complaints were generally issued within one to two weeks of a BCC determination to do so.
With respect to the commencement of disciplinary hearings and appellate hearings, and the subsequent issuance of a written decision, the Division identified one case in which it believes that the process should have been completed in a more timely manner. As noted earlier, in Disciplinary Case No. 01-782-94, the Appeals Committee affirmed the decision of a Hearing Panel. A complaint originally was issued against four members on June 6, 1994. The charges were settled with respect to three members and a hearing regarding the fourth member was conducted on November 9 and 15, 1995, and February 20 and 22, 1996.62 On March 19, 1997, the Hearing Panel rendered its decision and imposed a $100,000 fine, a one-year suspension of membership privileges, and a permanent prohibition from executing customer orders. The member appealed the Hearing Panel's decision and an Appeals Panel conducted an appellate hearing on December 1, 1997. The Appeals Panel subsequently issued a written decision and order on April 23, 1998.
The Division found that a considerable amount of time lapsed between the date that the complaint was issued and the date that a disciplinary hearing commenced (17 months), and the date that the hearing ended and the Hearing Panel issued its decision (13 months). This delay is inconsistent with Commission Regulation 8.17(a)(3) which requires that disciplinary hearing be conveyed promptly after reasonable notice. Moreover, the Exchange's own rules require that the Adjudication Committee issue a written decision within 45 days after the later of a hearing or the last day any post-hearing memoranda were required to be filed, unless additional time is required due to the complexity of the case.63 The Division recognizes that the case involved a complex factual pattern of 21 different trading sequences among four members, but nevertheless believes that the Exchange must implement procedures to ensure that Adjudication Committee hearings are held promptly after a complaint is issued. Furthermore, the Division also believes that the decisions of the Hearing Panel and the Appeals Committee should have been rendered in a more timely manner.
F. Conclusions and Recommendations
Based upon its review, the Division found that the Exchange generally maintains an adequate disciplinary program. Disciplinary matters are promptly referred to the BCC and findings in cases that proceed for further action appear to be supported by the evidence. The Exchange imposed summary fines totaling $14,150 for trading card recordkeeping and trade timing violations. In addition, the Exchange imposed non-summary fines totaling $115,000 and issued membership suspensions totaling 370 days for various trade practice violations. Although the penalties appear reasonable relative to the conduct being sanctioned and take into account members' prior disciplinary histories, the Division believes that restitution should be included in all settlements and decisions where customer harm can be determined to ensure that injured customers are appropriately compensated for losses due to a member's abusive trading activity.
With regard to the timeliness of disciplinary procedures, the Division found one instance in which 17 months passed between the date when a complaint was issued and the date that an Adjudication Committee Hearing Panel held a hearing. In addition, 13 months passed before the Hearing Panel issued a decision. That decision, which imposed substantial sanctions, was upheld by an Appeals Panel. However, the Appeals Panel did not issue its decision until four and one-half months following the appellate hearing. The Division believes that the Exchange should implement procedures to ensure that Adjudication Committee hearings are held promptly after a complaint is issued. In addition, the Adjudication Committee and the Appeals Committee should improve the timeliness of issuing decisions once a proceeding is concluded.
Based on its review, the Division recommends that COMEX:
- Order restitution in all settlements and Exchange disciplinary decisions where the amount of customer harm can be determined.
- Take action to ensure that Adjudication Committee hearings are held promptly after a complaint is issued and that Adjudication Committee and Appeals Committee decisions are issued in a more timely manner.
1 Rule enforcement reviews prepared by the Division are intended to present an analysis of an exchange's overall compliance capabilities for the period under review. Such reviews deal only with programs directly addressed in the review and do not assess all programs. The Division's analyses, conclusions, and recommendations are based, in large part, upon the Division's evaluation of a sample of investigatory cases and other exchange documents. This evaluation process, in some instances, identifies specific deficiencies in particular exchange investigations or methods but is not designed to uncover all instances in which an exchange does not address effectively all exchange rule violations or other deficiencies. Neither is such a review intended to go beyond the quality of the exchange's self-regulatory systems to include direct surveillance of the market, although some direct testing is performed as a measure of quality control.
2 In addition, the Exchange's market surveillance program was evaluated in a separate rule enforcement review presented to the Commission on April 2, 1998.
3 62 FR 26480 (May14, 1997).
4 Commission staff's examination of the Exchange's surveillance system and disciplinary program with respect to the Exchange's dual trading exemption petition did not include the review of individual investigation and disciplinary case files.
5 Section IV.B.3. below includes a discussion of trading card issues.
6 COMEX Rule 4.80 also requires that floor members record all trades on trading cards, including customer trades.
7 Each member who executes transactions on the floor must be unconditionally guaranteed by a qualified guarantor which is the member's PCM. Although under COMEX Rule 4.80(g) members also have the option of submitting original trading cards to their PCM for timestamping rather than the Exchange, in practice, the vast majority of members submit their trading cards directly to the Exchange.
8 The Exchange considers a customer's account number or a unique code traceable to that account an acceptable account identifier.
9 Section 5a(b)(2) of the Act establishes that an audit trail system of each exchange must accurately record the one-minute execution times of trades and sequence trades for each floor trader and broker. Commission Regulation 1.35(g) requires an exchange to obtain the actual one-minute time of execution on each side of a trade or, if an exchange identifies and records the time, to obtain a single actual time. To comply with the one-minute timing requirement, COMEX requires floor members to record manually on a trading card the minute of execution for each side of a trade.
10 These floor order ticket reviews include three quarterly reviews opened prior to the target period and five bimonthly floor order ticket reviews that were closed during the target period. The Division found that 918 floor order tickets were examined as part of the three quarterly reviews and that 1,232 floor order tickets were examined during the five bimonthly reviews. Although the Exchange's procedures stipulate that a minimum of 30 floor order tickets will be selected for review, during the target period, the actual number of tickets examined as part of the completed bimonthly reviews ranged from 63 to 537. The 30 ticket minimum is in place to accommodate the smaller, less active broker groups.
11 The Division examined order tickets associated with an order ticket review completed after the target period because the Exchange returns order tickets to clearing firms once an order ticket review is completed. Because the January 1998 floor order ticket review was completed outside the target period, the statistical results are not included in the Division's total count of floor order tickets examined by the Exchange during the target period.
12 As noted above, PCMs are responsible for maintaining members' original trading cards.
13 The Broker vs. PCR Report evaluates trade times by comparing the times recorded by brokers and traders on their trading cards to the time recorded in the Exchange's price change register ("pCR"). COMEX deems a trade execution time to be accurate when it is within one minute on either side of the minute that a corresponding price was reported in the PCR. Based on this comparison for all trades executed during the preceding month, the Broker vs. PCR Report generates a monthly accuracy percentage for every COMEX broker and trader.
14 The Broker vs. Broker Report compares floor members' reported execution times for several randomly selected days each month to the times reported by floor members for the opposite side of the trade to identify instances where the buy and sell times do not match.
15 The Broker On-Time Trade Summary Report identifies members who fail to input trade data through the Exchange's On-Line Trade Entry System within 30 minutes following the 30-minute trading bracket during which the trade occurred.
16 Re-reviews of members are conducted within six months of the initial audit trail review when the member was found deficient. Members who are re-reviewed are tested for compliance with all audit trail requirements, not only the rules that the member initially failed.
17 The Exchange explained to the Division that it does not review the complete group selected for an audit trail review for collection timeliness because the review is extremely time consuming and labor intensive. Although Exchange procedures call for the Compliance Department to examine a minimum of five members per month for collection timeliness, in practice, the Compliance Department examines more. For the 13 audit trail reviews closed during the target period, the number of members reviewed for collection timeliness ranged from four members to 11, with an average of seven members reviewed each month. In addition, as discussed below, all trading cards examined during the course of a trade practice investigation are checked for collection timeliness. See note 19.
18 The Division stated in the 1993 Review that COMEX could enhance the usefulness of its monthly audit trail reviews by increasing the number of trading cards and members examined. The Division had found that, for the target period then under review, the Exchange had completed 14 audit trail reviews for which it reviewed a total of 2,742 trading cards, an average of 196 cards per month, and that the number of members selected for each review ranged from eight to 22. Thus, the Exchange's new audit trail review procedures have increased by more than five times the number of trading cards examined and have significantly increased the number of members examined.
19 Trading cards reviewed in conjunction with a trade practice investigation are subject to the same standards of review that exist for audit trail reviews and are also tested for collection timeliness.
20 As explained in Section V.D.1. below, the Division examined all of the trade practice investigations closed by the Exchange during the target period.
21 The Compliance Department concluded in Investigation No. 06-973-050697 that two members engaged in five instances of noncompetitive prearranged trading from May through September 1997. Subsequent to the close of the target period, one member was ordered to pay an $11,000 fine and the other member was ordered to pay a $15,000 fine.
22 This also was a problem identified by the Division in the 1993 Review. Toward that end, the Division recommended that the Exchange improve member compliance with the requirement that a new trading card be used at the beginning of each designated 30-minute trading interval. The Division notes that the problem identified during the present review is largely attributable to two members out of the group of 20 members whose trading cards were examined. In addition, the illegibility of a large number of trade times for one of these members had a substantial impact on the overall trading card recordkeeping score of the entire group.
23 Since members are required to use a new trading card at the beginning of each 30-minute bracket, all trades recorded on a single trading card should be executed during the same hour.
24 As explained below, during the target period, the Exchange began an initiative to hire more experienced trade practice surveillance staff. Therefore, the Division's evaluation of COMEX's staffing went beyond the target period and is intended to present a clear picture of the Exchange's trade practice surveillance staff as of May 1999. A listing of trade practice surveillance personnel and an organizational chart can be found in Appendix 1.
25 See May 4, 1999 letter from David Schneiderman, Director, Trade Practice Surveillance, to Rachel Berdansky, Special Counsel, Division of Trading and Markets, included in Appendix 2.
26 CTI is a numerical code used to identify the source of trades as follows: CTI 1 designates a trade by a member for his or her personal account or an account for which he or she has discretion; CTI 2 is a trade for his or her clearing member's house account; CTI 3 is a trade for another member present on the floor or an account controlled by such other member; and CTI 4 is a trade for any other type of customer.
27 Samples of TSER review logs are included in Appendix 3.
28 The Broker Unmatched Trade Report shows all unmatched trades broken down by member for a specific date. The Correction Audit Trail Report displays intra-day changes made to the details of a trade and is sorted by transaction identification number. The Trade Audits Department, which is not part of the Exchange's Compliance Department, assists members with trade corrections.
29 Samples of the Compliance Department's floor observation schedules and memoranda with instructions to staff are included in Appendix 4.
30 Samples of Weekly Floor Observation sheets are included in Appendix 5.
31 Samples of the COMEX Division Open Case List are included in Appendix 6. Commission Regulation 8.06 requires that an investigation generally be completed within four months, except when significant reason exists to extend it beyond that time frame. Significant reasons may include the complexity of the matter, as well as the number of documents required to be analyzed in order to properly determine if a rule violation occurred.
32 The Division referral involved possible trading ahead by 19 Exchange members. The Exchange subdivided the referral into 19 separate investigations. After reviewing the involved members' trading records, Compliance Department staff determined that there was not a reasonable basis to believe that Exchange rules were violated, except in one instance. However, warning letters were issued to eight members for various trading card violations discovered during the course of the investigations. The investigation regarding the instance in which the Compliance Department believed that a member may have traded ahead of his customer's order, Investigation No. 06-023-121097, was still ongoing at the end of the target period.
33 A December 9, 1997 letter from David Schneiderman, Director, Trade Practice Surveillance, to Rachel Berdansky, Special Counsel, Division of Trading and Markets, describes this policy and is included in Appendix 7.
34 Ten closeout memoranda were written between one and two months after the appropriate sign-off sheets were signed, one was written three months after a sign-off sheet was signed, one was written six months after a sign-off sheet was signed, two were written seven months after sign-off sheets were signed, one was written ten months after a sign-off sheet was signed, and one was written 15 months after a sign-off sheet was signed.
35 There were two investigations that were open prior to the target period and remained open at the close of the target period. Investigation No. 06-962-04197 was closed by the Compliance Department on January 22, 1999, and was referred to a disciplinary committee. On February 24, 1999, a complaint was issued against two members alleging various violations of Exchange rules involving prearranged and non-competitive trading. The other investigation, Investigation No. 06-932-110596, involved a member who had previously been sanctioned. Because this member had failed to pay his monetary penalty, his membership was revoked. The Compliance Department did not actively pursue the more recent investigation due to the revocation.
36 Contract Market Rule Enforcement Program Guideline No. 2, 1 Comm. Fut. Law Rep. (CCH) ¶ 6430 (May 13, 1975).
37 Section IV.B.1. above describes the Exchange's recordkeeping summary disciplinary program.
38 Disciplinary Rule 3.13 requires that the COMEX Panel be comprised of 70 percent COMEX members and 30 percent NYMEX members. The rule further requires that the nine members include at least one person who is neither an Exchange member nor employed by an Exchange member or member firm. The remaining committee members are to include floor brokers, locals, traders, and FCMs.
39 Disciplinary Rule 3.10 requires that each COMEX Hearing Panel be comprised of 70 percent COMEX members and 30 percent NYMEX members. The rule further requires that each Hearing Panel include at least one person who is neither an Exchange member nor employed by an Exchange member or member firm. The remaining Hearing Panel members are to include floor brokers, locals, traders, and FCMs.
40 Disciplinary Rule 8.16.
41 Disciplinary Rule 3.03 defines disqualifying disciplinary offenses generally to include any violation of the Act or Commission regulation, and any violation of a self-regulatory organization's rules, except those rules related to: (1) decorum or attire; (2) financial requirements; or (3) reporting or recordkeeping, provided that the violation(s) did not result in fines aggregating $5,000 or more within a single calendar year.
42 Disciplinary Rule 8.03. Any settlement agreement approved by or entered into with the BCC is subject to Board approval.
43 Disciplinary Rule 8.02(C).
44 Disciplinary Rule 8.02(D).
45 The BCC also will direct the Compliance Department to notify the subject of its findings. Disciplinary Rule 8.02(E).
46 Disciplinary Rule 8.03(B) and (D).
47 Disciplinary Rule 8.04(C) defines "respondent" as a member, member firm, or employee of any of the foregoing against which a complaint has been filed.
48 Under Disciplinary Rule 8.05, the respondent may file a written answer to the complaint and request a hearing within ten business days of service of the complaint. Disciplinary Rule 8.04(D) provides that the respondent's failure to request a hearing within the provided time frame will generally operate as a waiver of a right to a hearing.
49 Disciplinary Rule 8.08.
50 Disciplinary Rules 8.11(D) and (E).
51 Disciplinary Rules 8.11(A), (B), and (K).
52 Disciplinary Rules 8.12(A) and 8.13.
53 Disciplinary Rules 8.16, 8.17, 8.18, 8.19, and 8.20 include a complete description of the Exchange's appeals process.
54 The Disciplinary Register is a list of all disciplinary actions taken by the Exchange and includes for each action, among other things, the name of the respondent, the investigation number and assigned disciplinary case number, the date the investigation resulting in disciplinary action was initiated, the date an action was presented to the BCC, the date any complaint was served or settlement reached, the date any hearing was held, rule violations charged, and sanctions imposed.
55 Subsequent to the target period, additional penalties were imposed in two disciplinary actions that were pending during the target period. These penalties included a $15,000 fine, a two-week suspension, and a cease and desist order for noncompetitive trading. None of the members involved in either action had a previous disciplinary history.
56 The Hearing Panel's decision for Disciplinary Case No. 01-782-94, discussed in more detail below, was issued prior to the target period.
57 On July 23, 1998, the NFA issued a notice of intent to revoke the member's registration based on the Exchange's disciplinary action. Three other members also were involved in the original matter. However, these three members executed settlement agreements with the Exchange prior to the target period and were sanctioned as follows: one member was fined $15,000 and was suspended for one-week; one member was fined $50,000, of which $25,000 was suspended with the proviso that any subsequent similar rule violations would result automatically in the imposition of the suspended portion of the fine, and the member was suspended for four weeks (a recent Commission action statutorily disqualified this member); and one member was fined $2,000.
58 Disciplinary Case No. 97-03.
59 The Division recommended in the 1993 Review that the Exchange consider members' past disciplinary history when imposing penalties.
60 Disciplinary Case No. 97-04.
61 A notice of charges is the equivalent of the Exchange's complaint and states the conduct in which the member is alleged to have engaged, the rule violation alleged, the predetermined penalty, and the member's rights with respect to a hearing. Commission Regulation 8.11.
62 See note 57 for a description of the terms of the settlements.
63 Disciplinary Rule 8.11(B).