A recent court order in favor of the Commodity Futures Trading Commission (or CFTC) and new rules issued by CFTC establish a standard of liability for depository institutions that fail to fulfill their customer funds protection obligations under the Commodity Exchange Act (or CEA) and, thus, requires them in certain circumstances to monitor the activities of clients that are registered with CFTC as futures commission merchants (or FCMs), commonly known as commodity brokers. This client alert summarizes the court order and the new rules and, then, discusses the implications for depository institutions and certain related preventive measures that they should consider implementing. I. The Court Order The court order relates to the banking relationship of a depository institution with Peregrine Financial Group, Inc. (or Peregrine), an FCM registered with CFTC, and the millions of dollars in customer funds allegedly deposited with the institution over the course of its banking relationship with Peregrine and Russell Wasendorf, Sr. (or Wasendorf), Peregrine’s owner and chief executive officer. During the course of that relationship, Wasendorf defrauded more than 24,000 of Peregrine’s customers and was eventually sentenced to 50 years in prison and ordered to pay more than $215 million in restitution. According to CFTC, Peregrine deposited more than $308 million of its customers’ funds with the depository institution during the eight years leading up to the discovery of the fraud. The funds of Peregrine’s customers were received by the institution in a customer account that, according to CFTC, the institution knew was subject to the CEA’s segregation requirement and CFTC rules intended to protect customer funds, including rules that prohibited those funds from being held, disposed of or used as belonging to Peregrine or any other person except the customers of Peregrine. CFTC alleges in its case that the depository institution improperly held or used the funds of Peregrine’s customers by permitting the customer account to be used, over the course of a series of transactions involving Wasendorf or an entity controlled by Wasendorf, in a manner that the institution knew was not for the benefit of Peregrine’s customers but was for the benefit of Wasendorf or other parties. For instance, according to CFTC, the depository institution knowingly allowed and facilitated the withdrawal of funds from the customer account to pay for, among other things, Wasendorf’s private airplane, his restaurant, his personal investments and his divorce settlement. In each case, according to CFTC, the transactions were carried out by the institution in violation of the CEA and CFTC’s regulations. The institution moved to dismiss CFTC’s case, arguing that the case is insufficient to state a claim for violation of the CEA resulting from its alleged failure to supervise withdrawals from Peregrine’s customer account because the CEA does not impose a duty on banks to monitor the transactions of their FCM clients. However, the court issued an order denying the motion to dismiss, endorsing CFTC’s prior interpretation that banks may be violating the CEA or be aiding and abetting a violation by acquiescing to the withdrawal or use of customer funds for an unlawful purpose where they have reason to know customer funds potentially are being misappropriated. Accordingly, the court found that CFTC made sufficient factual allegations regarding the depository institution’s knowledge and conduct in holding Peregrine’s customer account while facilitating the withdrawal of customer funds.
II. CFTC’s New Rules
Motivated in part by the Peregrine case, CFTC issued new rules establishing the interpretation endorsed by the court as the standard of liability for depository institutions and expanding their obligations to monitor the activities of FCM clients. The new rules will become effective on January 13, 2014 and supplement the rules of the National Futures Association (or NFA), a self-regulatory organization for the U.S. derivatives industry, imposing requirements on depository institutions that hold customer funds for FCMs. They require an institution to sign a new written acknowledgement letter, in the form provided by CFTC and attached to this client alert as an appendix, within 180 days after the effective date and within 120 days of any changes in the name or address of its FCM client or the institution or in the account numbers under which customer funds are held. The form of the acknowledgement letter contains several undertakings that have not previously been required of depository institutions. Additionally, a depository institution must agree that it may presume any withdrawal from customer accounts and the balances maintained therein are in conformity with the CEA and CFTC regulations without inquiry unless, in the ordinary course of its business, it has notice or actual knowledge of a potential violation by an FCM of any provision of the CEA or CFTC regulations that relates to the segregation of customer funds.
In establishing the foregoing standard of liability as a contractual requirement, CFTC reaffirmed its long-held interpretive position that a depository institution will be held liable for the improper transfers of customer funds by an FCM if it knew or should have known that the transfers were improper. Additionally, CFTC emphasized that, while an institution has no affirmative obligation to police or monitor an FCM client’s compliance with the CEA or CFTC regulations, the institution cannot ignore signs of wrongdoing. CFTC also stated that, if an institution knows or suspects that funds held in a customer account have been improperly withdrawn or otherwise improperly used in violation of the CEA or CFTC regulations related to the segregation of customer funds, CFTC expects the institution to immediately report its concern to CFTC. Further, like the CEA and the existing CFTC regulations being replaced, the new rules provide that no person, including a depository institution, that has received FCM customer funds for deposit in a segregated account may hold, dispose of or use those funds as belonging to any person other than the customers of the FCM that deposited the funds.
III. Preventive Measures
Although the outcome of the Peregrine litigation may furnish an answer as to whether the alleged violations of the CEA and CFTC regulations are supported by the facts, the litigation itself should be viewed by depository institutions as a reason to increase internal oversight of transactions and other business activities involving clients that are registered with CFTC as FCMs or in other capacities, such as commodity pool operators or commodity trading advisors. To avoid possible violations of the CEA and CFTC regulations arising from the segregation or use of customer funds, institutions should, first, identify and review their relationships with CFTC-registered entities. The circumstances surrounding Wasendorf’s fraud may be unique, but the type of banking relationship that allegedly existed with Wasendorf and Peregrine arguably is not. Maintaining a client’s goodwill and protecting an institution’s relationship with a client may be necessary, but given the potential liability that the depository institution in the Peregrine litigation faces as a result of CFTC’s court case, the focus of the review should be to ensure that a depository institution is not accommodating CFTC-registered clients at the expense of compliance with applicable laws and regulations.
If relationships with CFTC-registered clients are identified, then a depository institution should review those relationships from time to time. The institution should obtain all information necessary to enable it to properly distinguish accounts containing customer funds from accounts containing assets of the CFTC-registered client or assets of related parties (so-called house assets). For all accounts that hold customer funds, a depository institution should obtain all information necessary to enable it to properly distinguish customer funds from house assets in those accounts. An institution also should ensure that those accounts are held as segregated trust accounts under account names that clearly identify them as customer accounts and show that they are segregated. In addition, a depository institution should collect from CFTC-registered clients, on an ongoing basis, information that allows it to credit customer funds to the proper accounts, verify the amounts of customer funds and house assets it should be holding in customer accounts and confirm that the funds it is asked to transfer from customer accounts are being disposed of by it properly in light of its "know your customer" information and other knowledge.
Further, a depository institution should create written compliance policies and procedures (or update existing policies and procedures), and follow them, to ensure that customer funds deposited by CFTC-registered clients are held, disposed of and used properly by the institution. Its personnel should be trained on those policies and procedures, and the institution should establish controls on transactions involving funds in customer accounts and other activities regarding CFTC-registered clients and related parties. The performance of banking functions should be allocated among different personnel as appropriate for the related tasks, and the depository institution’s internal auditors should be charged with ascertaining compliance with the institution’s compliance policies and procedures.
In addition, a depository institution should have its counsel or compliance personnel review any written acknowledgements for customer accounts and any loan or other documents involving CFTC-registered clients or related parties to ensure that customer funds are not taken as collateral for, or relied upon or treated as being available to satisfy, the so-called "house obligations" of those clients or related parties. In addition to signing new written acknowledgement letters in the form prescribed by CFTC, the institution should have its counsel promptly clarify legal documents by letter or amendment to limit its responsibilities, to re-define secured obligations and related collateral and to make any other appropriate modifications. Any necessary changes to those documents or any other legal documents should be made expeditiously. Also, an institution should consider having its counsel supplement existing CFTC-registered client and related party relationship documents with indemnity letters and other client assurances, including covenants to furnish all necessary information and take all other actions reasonably requested to permit the institution to segregate, hold, dispose of and use customer funds in compliance with applicable laws and regulations.
A depository institution also should consider designating their CFTC-registered clients as higher risk customers for purposes of the Bank Secrecy Act and anti-money laundering laws and regulations. The institution should consider whether it receives in any or all cases, either as a result of its customer identification and due diligence processes or otherwise, sufficient information for it to be required to monitor the activities of its CFTC-registered clients not only for the foregoing purposes but for purposes of the Commodity Exchange Act and CFTC rules as well. In any event, an institution should review the regulatory compliance management systems of its CFTC-registered clients, including any expectation that those clients subject themselves to third party testing and review in order to (among other things) verify for the institution that the clients are using, holding and disposing of customer funds properly.
Finally, a depository institution should consider taking the foregoing preventive measures in respect of clients that are regulated by governmental authorities other than CFTC or that may have deposited customer funds at the institution. These clients might include, for instance, trustees and other fiduciaries or broker-dealers and investment advisers regulated by the U.S. Securities and Exchange Commission.
Hunton & Williams attorneys are available to furnish more information on these matters, to assist you in complying with the CEA, CFTC regulations and other applicable laws and to review and/or revise your compliance policies and procedures. If you would like to discuss the matters addressed herein, please contact one of the following attorneys:
Joseph B. Buonanno [email protected]
Peter Weinstock [email protected]
Landon S. Eustache [email protected] |