CFTC Fines Firm for Supervision and Records Failures Relating to Its "Know Its Customer" Procedures
Commentary by Bob Zwirb
The CFTC issued an order filing and settling charges against an FCM for improper supervision and records violations. According to the CFTC order, the firm failed to "diligently" supervise the way its officers, employees and agents opened and handled accounts in the name of a family of companies that turned out to be an ongoing $35 million Ponzi scheme based in the United Kingdom.
The relevant account, according to the CFTC, involved operating a hedge fund based in part in the British Virgin Islands, which was deemed a "high risk jurisdiction" under the firm's compliance procedures. Under those circumstances, the firm's own heightened compliance procedures required personnel of the firm to, among other things, "know its customer" and be alert to any "red flags" regarding suspicious activity prior to opening an account. The order found that, despite unresolved red flags, the firm opened the client's accounts.
Additionally, the order found that the firm (i) failed to properly enforce its own trading limits assigned to the accounts, which resulted in initial margin requirements that far exceeded the credit trading limit, (ii) did not respond timely and accurately to a CFTC request for production of account records, and (iii) did not maintain adequate records regarding the applicable credit trading limits.
See: CFTC Order.
Commentary
The failure-to-supervise violations here are based in part upon the firm's failure to adhere to its own requirements – i.e., those that it imposed on itself in its compliance manual – rather than to those imposed by the CFTC. The FCM's failure to "know its customer" violated its own standards of due diligence, as codified in its manual; although NFA Rule 2-30 imposes certain "know your customer" obligations upon FCMs, these relate primarily to obtaining information about the customer's experience, income, net worth and age before opening an account.
Similarly, the trading limits breached here were those of the FCM, not those of the CFTC. Nevertheless, a violation of a firm's internal controls may give rise to an independent violation of the CEA via CFTC Rule 166.3, which requiresregistrants diligently to supervise their personnel. This matter illustrates the elastic nature of the CFTC's supervisory requirements and the legal risk they pose for registrants.
The lesson here is that firms need to comply with the standards set out in their compliance manuals and not simply with government regulations. Thus, it behooves those regulated by the CFTC (as well as the SEC) to adhere to the requirements spelled out in their own compliance manual – and, conversely, not to establish requirements in their manuals that they themselves have not established procedures to meet.