IV. TRADE PRACTICE SURVEILLANCE PROGRAM

Core Principle (2) - Compliance with Rules:

The board of trade shall monitor and enforce compliance with the rules of the

contract market, including the terms and conditions of any contracts to be traded

and any limitations on access to the contract market.

Core Principle (12) — Protection of Market Participants:

The board of trade shall establish and enforce rules to protect market participants

from abusive practices committed by any party acting as an agent for the

participants.

Pursuant to Appendix B to Part 38 of the Commission’s regulations, a contract market’s
trade practice surveillance program should have the arrangements, resources, and authority
necessary to perform effective rule enforcement. The arrangements and resources attendant to
the program should facilitate the direct supervision of the contract market, including analysis of
relevant data. The program also should have the authority to discipline, suspend, or terminate
the activities of members or market participants pursuant to clear and fair standards.

An acceptable trade practice surveillance program should maintain all data reflecting the
details of each transaction executed on the contract market. In this regard, the program should
include routine electronic analysis of these data to detect potential trading violations.
Additionally, the program should provide for appropriate and thorough investigation of all
potential trading violations brought to the contract market’s attention. Further, an acceptable
trade practice surveillance program should provide for prompt and effective disciplinary action
for any violation that is found to have been committed.

A. Compliance Staff
The Compliance Department, which is responsible for detecting, investigating, and

prosecuting trading violations on both the COMEX and NYMEX Divisions, is headed by the

18



Case 06-045 involved five Exchange members. One respondent was fined $12,500,
ordered to pay $3,150 in customer restitution, and suspended for three weeks for noncompetitive
trading, improper cross trading, prearranged trading, prohibited dual trading, and improper
recordation of trades. A second respondent was fined $3,000 and suspended for two weeks for
noncompetitive trading, prearranged trading and improper recordation of trades, while a third
respondent was fined $6,000 (including $2,000 in suspended fines) for noncompetitive and
prearranged trading. One remaining respondent received a BCC warning letter and the other
received a staff warning letter. In Case F-02, the respondent member was fined $17,500 and
ordered to pay customer restitution of $23,781.10 for violation of Exchange rules regarding
customer margin requirements and member accounts, failure to report reductions in licensee
capital, failure to maintain minimum capital requirements, and conduct detrimental to the
Exchange.**

The Division believes that the penalties imposed appear reasonable relative to the
conduct being sanctioned. The penalties also appear sufficient to deter future similar violations.

E. Conclusions and Recommendations

Based upon its review, the Division found that the Exchange maintains an adequate
disciplinary program. The Exchange’s rules and disciplinary structure give the Exchange
appropriate authority to discipline, suspend, or terminate the activities of members pursuant to
clear and fair standards. During the target period, the Exchange issued complaints with
reasonable promptness after cases were sent to the BCC, and moved with reasonable promptness
after issuance of complaints to conclude the disciplinary process and impose sanctions. During

the target period, the Exchange assessed $44,000 in fines against five members and imposed

58 The remaining case involved a member who was fined $5,000 and ordered to pay $12,105 in restitution to the
Exchange for destruction of Exchange property.

39


When an investigation report is submitted to the BCC, a copy is served on the Exchange
member who is the subject of the report. The member then has five days to submit a written
statement and supporting documentation to the BCC for its consideration.*® The COMEX Panel
of the BCC then considers the matter at its next bimonthly meeting following expiration of this
five day period. Members against whom Compliance has recommended charges may appear and
make oral presentations to the COMEX Panel of the BCC, but may only address matters raised
in their written responses to the investigation report.’” If the BCC determines that a reasonable
basis exists for finding that a rule violation has occurred, it may return the matter to Compliance
for further investigation, issue a warning letter, or direct Compliance to issue a complaint.”®

When Compliance issues a complaint, it is delivered to the respondent member, filed
with the Exchange’s Hearing Registrar, and forwarded to the Adjudication Committee, along
with any written response or request for hearing from the respondent and any written reply from
Compliance.” The Chairman of the Adjudication Committee assigns the case to one of the two
COMEX Hearing Panels for hearing and decision. Ifa settlement offer is made at this stage, it is
considered by the other COMEX Hearing Panel, and if approved is subject to Board approval.
The Hearing Panel may agree to the same sanctions which may be imposed by the BCC, as noted
above, except that fines may be levied up to $250,000 per violation, and there is no limit on the
length of a suspension.

If the respondent admits or fails to deny any rule violation charged in the complaint, the
Hearing Panel must impose a penalty for each violation, and notify the respondent within 45

“6 See Disciplinary Rule 8.02.
47 See Disciplinary Rule 8.02(D).
‘8 See Disciplinary Rule 8.02(E). The BCC will also direct Compliance to notify the subject member of its findings.

* Under Disciplinary Rule 8.05, the respondent may file a written answer to the complaint and request a hearing
within 10 business days after service of the complaint. Under Disciplinary Rule 8.04(D), failure to request a hearing
within the 10-day period constitutes a waiver of a right to a hearing.

35


Exchange or the member’s PCM within 15 minutes after the end of the half-hour bracket in
which the card was used. Compliance staff examine approximately 10 trading cards for each
selected member and compares the trade times manually recorded on the front of the card with
the collection timestamp on the back of the card. 1s

A member’s trading cards are reviewed for compliance with eight recordkeeping
requirements set forth in Rule 4.80. The requirements are specified in COMEX’s Trading Card
Review Checklist.'® Staff will also follow up on other types of possible violations detected
during the course of a trading card review. A member with no discrepancies in any of the eight
categories is determined to be in “Full Compliance,” and a member with a compliance rate of 90
percent or better is noted as being in “Effective Compliance.” A member who fails to meet these
standards is found to be “Not in Compliance,” and is subject to summary disciplinary action. A
warning letter is issued for the first finding of “Not in Compliance;” a second infraction within a
12-month period results in a $100 fine; and a third infraction within 18 months results in a $500
fine. A fourth infraction within 24 months results in a referral to the Business Conduct
Committee (“BCC”) for formal disciplinary action.'”

During the 11 monthly trading card reviews completed during the target period,

Compliance staff examined a total of 7,197 trading cards used by 289 members, an average of

'5 See COMEX Rule 4.80(g). The Exchange explained to the Division that it does not review the trading card
collection timeliness of the complete group selected for a trading card review because the process 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. In the course of the 11 trading card reviews closed during the target period, a total of 75 members were
reviewed for collection timeliness, an average of approximately seven members reviewed each month.

'© The eight requirements examined include: time of execution to the nearest minute; delineation of opening and
closing range times; new trading card use at the start of each bracket period and the post-settlement session;
cancellation of unused lines; buys and sales recorded sequentially in chronological order without skipping or sharing
lines; timely submission of cards; use of non-erasable ink; and card use in numerical sequence intra-day. A copy of
the checklist is attached as Appendix 2.

'’ Disciplinary action is not limited to these summary procedures if Compliance finds substantive violations in
addition to trading card violations.

12


taking note of the size of the trades involved in a given pattern and the frequency with which the
members involved appear on the exception reports. They also attempt to identify suspicious
individual trades, and review exchange records relating to such trades. Analysts record any
findings from their review of TSER exception reports on the relevant exception log?

Compliance analysts supplement their review of TSER exception reports by conducting a
manual daily review of the DBR. As noted above, the DBR contains complete data for each
COMEX trade, including all open outcry and ACCESS trades. The DBR sorts trading data both
by executing broker and clearing member, and by executing broker and time of execution.

Analysts also consider information from three specialized, computer-generated reports
that detail particular types of trading activity. Compliance staff conduct a weekly review of the
Crossed Trades Report to detect possible violations of the Exchange’s prohibition against
members crossing their customer orders against their personal accounts, and review information
from the Broker Unmatched Trade Report and the Correction Audit Trail Report forwarded to
them by the Exchange’s Trade Audits Department.”*

C. Floor Surveillance

Exchange trade practice analysts routinely observe trading during the Exchange’s
opening and closing periods and during the middle of the Exchange’s trading day. A bimonthly
schedule assigns one analyst per week to spend at least 40 minutes on the floor each day for the

COMEX open and at least 40 minutes each day for the COMEX close, and assigns a second

25 Samples of TSER review logs are included in Appendix 3.

* 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 and member. The Trade Audits Department, which is not part of the Exchange’s
Compliance Department, assists members with trade corrections.

22


suspensions totaling five weeks for trade practice violations such as noncompetitive trading,
prearranged trading, and trading against customer orders. In addition, three members were
ordered to pay a total of $26,931.10 in restitution to customers. The penalties imposed appear
reasonable relative to the conduct being sanctioned.

Based on the foregoing, the Division has no recommendations at this time with respect to

the Exchange’s disciplinary program.

40


e trade practice investigation and disciplinary action files;
e files containing trading card and order ticket recordkeeping reviews;
* compliance manuals and guidelines; and

¢ minutes of Board of Directors and disciplinary committee meetings held during
the target period.

The Division provided the Exchange an opportunity to review and comment on a draft of
this report on August 8, 2002. On August 21, 2002, Division staff conducted an exit conference

with Exchange officials to discuss the report’s findings and recommendations.


The Adjudication Committee (“AC”) , through its Hearing Panels, conducts hearings to
determine whether rule violations have occurred, and levies sanctions for any violations found to
have been committed. A Hearing Panel can also enter into settlement agreements with charged
members. The AC is divided into two COMEX and two NYMEX Hearing Panels, each
consisting of 10 members and designated alternates.*!

Appeals from Hearing Panel decisions are heard by the Appeals Committee, whose
members are selected by its Chairman. In the event of an appeal, the Chairman appoints an
Appeals Panel consisting of three committee members, one of whom must be a COMEX
member.”

All members selected to serve on an Exchange disciplinary committee must be approved
by the Board of Directors (“Board”). They may not sit with respect to a matter under
consideration if they have any direct financial, personal, or other interest in it. Any person who
participated in any prior stage of the disciplinary process is not eligible to serve in a higher
decisional capacity for the same proceeding. In addition, a person is prohibited from serving on
any disciplinary body if within the prior three years he or she has been found to have committed
a disqualifying disciplinary offense or entered into a settlement agreement finding that he or she

committed such an offense.”

“' 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 a member’s employee. The remaining Panel members are to include floor
brokers, locals, traders, and FCMs.

*® See Disciplinary Rule 8.16.

® Disciplinary Rule 3.03 defines disqualifying disciplinary offenses generally to include any violation of the Act or
Commission regulations, and any violation of a self-regulatory organization’s rules, except those rules related to
decorum or attire, financial requirements, or reporting or recordkeeping, providing that the violations of the
excepted rules did not result in fines aggregating $5,000 or more within a single calendar year.

33


Vice President of Compliance. Including the Vice President, the Trade Practice Surveillance
unit consists of 20 staff members.

The Director of Trade Practice Surveillance has overall responsibility for the
investigation and prosecution of rule violations, and is assisted in the day-to-day management of
the trade practice surveillance program by an Associate Director. One Compliance Counsel and
one Associate Counsel support the Trade Practice Surveillance unit. The Compliance Counsel
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, the Director
and Associate Director ultimately determine whether evidence supports the Compliance
Department recommending that an investigation be referred to a disciplinary committee.

In addition to the personnel described above, the staff includes four managers, seven
analysts, and one clerk. ‘Additional support staff includes one project coordinator and two
secretaries. The Associate Director and managers, who report to the Director, oversee
investigations and provide general guidance to the analysts and clerk. 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, order ticket and trading card reviews, and investigating
potential violations which are indicated by the computerized reports or referred to the Exchange
by other sources such as customers, members, or the Commission. The secretaries and clerk
perform administrative functions and conduct certain trading card review procedures.

Cases are assigned to analysts based on managers’ assessments of analysts’ workloads
and experience. Analysts rotate to all types of compliance assignments, and work with all of the

managers on a rotating basis in order to learn from the particular expertise and experience of


receipt. A signed, timestamped copy is kept in the investigation file. When the requested
documents are received, the analyst reviews them along with other records, including relevant
TSER and PCR reports and DBR data, and conducts interviews of relevant persons. While the
initial direction and scope of an investigation may be determined by the alleged violation,
investigations are expanded when other potential violations become evident as the investigation
progresses.

Once the analyst conducting an investigation reaches a conclusion as to whether there is
sufficient evidence to support disciplinary charges, the analyst and his or her manager or
supervisor meet with the Director or Associate Director of Compliance, either of whom has
authority to decide whether to close the investigation without further action or to refer the matter
to the BCC with a recommendation that charges be brought.*? If the Director or Associate
Director of Compliance decide that the investigation should be closed without further action,
Compliance assigns the date of the meeting as the date the investigation is closed. The analyst
prepares a close-out memorandum summarizing the investigation and giving the rationale for the
decision not to proceed with disciplinary action. It is Compliance Department policy that
closeout memoranda be completed within three weeks of the decision to close the investigation.
After the memorandum is signed by the analyst and supervisor, and approved and signed by
either the Director or Associate Director of Compliance, it is retained in the file. Ifa staff
warning letter is appropriate in the circumstances, it is issued at the time the close-out
memorandum is approved. The subject(s) of the investigation, and any complainant involved,
are notified of the investigation’s close, in person or in writing, within 48 hours of completion of

the closeout memorandum. The Division reviewed the close-out memoranda included in all

*° In those relatively rare cases where Compliance staff find the decision on whether to recommend disciplinary
action to be a close call, the issue is considered in a meeting of the Vice President for Compliance, Compliance
Counsel, and the Director and Associate Director of Compliance, attended by the analyst and manager if needed.

25


schemes. The reports also are used to expand the scope of an investigation when potential
violative trading patterns are detected. The principal TSER reports include the following:

e The Trading Ahead Report identifies 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,
at a price equal to or better than the price received by the customer.

e The Preferential Trading Report lists instances where 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 that member’s trades were on the same
side of the market as the customer order, within five minutes before or after the
customer trade, at a price equal to or better than the price received by the customer.

e The Prearranged Trading 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.

e The Payback Report is designed to detect members’ potential prearranged trading
intended to facilitate a money pass between members. It identifies 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.

In addition to these reports, TSER also produces a summary report, Total of Members’
Appearances on Exception Reports Over Previous Two Months (“Summary Report”), that
identifies the frequency of members’ appearances on other reports during the previous two-
month period. The Summary Report is reviewed on an as-needed basis.

Each TSER report is generally assigned to the same analyst for daily review, but

assignments are rotated periodically so that each analyst becomes proficient in reviewing all of

the exception reports. Analysts look for trading patterns indicating possible illegal activity,

21


B. Disciplinary Procedures

If the Compliance Department determines that there is a reasonable basis to believe that a
member has violated an Exchange rule, it forwards to the BCC an investigation report prepared
as noted above. The investigation report includes the reasons for initiation of the investigation,
the relevant facts, and the Compliance Department’s conclusions and recommendations. In
addition, Compliance staff inform BCC members orally of the relevant disciplinary history of the
member(s) involved in the investigation report.

The Compliance Department may negotiate a settlement agreement prior to submitting an
investigation report to the BCC, subject to BCC approval of the agreement.** Such settlement
agreements reached prior to submission of a matter to the BCC may provide 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.

Once a matter has been submitted to the BCC for disciplinary action, the BCC may
consider settlement offers from the charged member(s) and may enter into settlement agreements
which may provide for any combination of the following sanctions: a cease and desist order; a
censure; an order directing restitution to any injured person; a fine not to exceed $25,000 for
each Rule violation alleged; or an expulsion or suspension from all or some rights and privileges
of membership, the ability to hold a permit, Electronic Trading Privileges, employment on the
Exchange Floor, or employment for the purpose of entering orders on ACCESS, for a period not

to exceed three (3) months for each Rule violation alleged."*

** See Disciplinary Rule 8.03. Any settlement agreement approved or entered into by the BCC is subject to Board
approval.

‘5 Id. Once a matter has been submitted to the BCC, the BCC cannot accept or enter into a settlement agreement
unless it is in writing and the Compliance Department has been allowed to respond to the proposed agreement in
writing.

34



which the OLTE clearing system also resides. Each day, DBR data is backed up on electronic
tape, and the tape is taken to the Exchange’s off-site backup facility in New Jersey, where it is
stored for five years.”!

In addition to its tape backup system, the Exchange retains microfiche copies of each
day’s DBR reports and Price Change Registers. Microfiche copies are retained at the main
Exchange facility for three years and in off-site storage for five years. The Exchange currently
has copies covering trading from 1997 to the present.” The Exchange also keeps month-to-
month statistics on the trading of each member, derived from DBR data, in a separate log
maintained both in hard copy and electronically on its Monarch trade surveillance system.

D. Conclusions and Recommendations

The Division found that, in general, the Exchange maintains an adequate audit trail
program. The Exchange maintains rules and procedures that provide for the recording and safe
storage of trade information in a manner that enables Compliance staff to use the information to
assist in prevention of customer and market abuses and to provide evidence of any rule
violations. The enforcement program consists of monthly trading card and bimonthly order
ticket reviews, which examine member compliance with recordkeeping requirements and the
accuracy of trade data. The Exchange’s order ticket and trading card reviews were thorough,
well documented and completed in a timely manner, and examination of these reviews indicated
high member rates of compliance with COMEX audit trail recordkeeping requirements.

However, the Division found that the Exchange’s floor order ticket reviews do not

provide for sufficient coverage of the Exchange’s floor broker population. Under its routine

2! The backup facility was moved to New Jersey from its previous Manhattan location adjacent to the World Trade
Center following September 11, 2001.

? The Exchange trade audit department retains hard copies of each day’s DBR and Price Change Register until
microfiche copies are made, a process which usually takes approximately 10 days.

16


history in a manner that protects the data from unauthorized alteration, accidental erasure or
other loss.
A. Exchange Order Flow and Recordkeeping Procedures

Open outcry orders at COMEX are typically transmitted to the trading floor either by
telephone or by electronic transmission over one of the electronic order routing systems used by
Exchange members. As required by COMEX Rule 4.81, each telephone order is recorded by the
floor broker’s clerk on an order ticket which notes the terms of the order and the customer’s
account identification, and is timestamped using a timestamping device synchronized to the
national atomic clock in Colorado. For each electronic order, the electronic order routing system
automatically prints the order terms, account identification, and time of the order.® If an order is
executable when received, the floor broker’s clerk transfers it to the floor broker in the trading
pit by either verbal communication or hand delivery of the paper order ticket or its printed
electronic order routing system equivalent. If an order is not executable when received, the floor
broker’s clerk may maintain it in his booth until it becomes executable, in most cases including it
in an order book listing orders by executability depending on the direction of the market. When
an order is executed, the floor broker or his clerk records the fill price in writing on the order
ticket. The order ticket is then brought back to the floor clerk’s booth, where the clerk contacts
the customer to confirm the fill and timestamps the order ticket a second time.

At the time of execution, the floor broker records the trade details on a pre-printed,
sequentially-numbered trading card, pursuant to COMEX Rule 4.80. Rule 4.80 requires floor
members to record the time of execution to the minute, the floor member’s identification, the
° The electronic order routing system used by one member firm for trades in gold, silver, and copper futures and
options transmits the order terms, account identification, and time of the order directly to an electronic trading pad

used in the ring by floor brokers trading for the firm to track their orders and trades. This proprietary system retains
all relevant data in its electronic audit trail.


G. Conclusions and Recommendations

The Division found that, in general, the Exchange maintains an adequate trade practice
surveillance program for monitoring and enforcing compliance with Exchange rules.
Compliance staff dedicated to trade practice surveillance are led by an experienced management
team and successfully develop timely investigations and prosecute disciplinary actions. All data
concerning each COMEX trade are available to Compliance staff through the Exchange’s
MONARCH computer system, and Compliance staff conduct routine electronic analysis of these
data to detect potential trading violations. Investigations were thorough, well analyzed, and
adequately supported by documentation, and were generally completed in a timely manner.
During the target period, the Exchange undertook significant and successful efforts to close its
older investigations and further ensure the timeliness of ongoing investigations.

The Division also found, however, that over the course of the year-long target period,
only three investigations were generated from the Exchange’s TSER exception reports. Since
TSER is COMEX’s principal tool for independently identifying possible trading violations, the
reports would be expected to be the source for a preponderance of the investigations generated
by Compliance and to lead to a larger number of investigations. With the exception of routine
recordkeeping reviews, most of the Exchange’s investigations during the target period were
dependent on outside sources.

Based on the foregoing, the Division recommends that the Exchange:

e Reexamine its program of TSER exception report review, and make modifications
necessary to increase the number of investigations generated.

31


order tickets, improperly recorded trades, and misconduct.** Another example is Investigation
No. 06-158. In this investigation, Compliance staff combined information from TSER reports
with extensive document review and appropriate interviews. The investigation resulted in a
complaint against two members for noncompetitive and prearranged trading, crossing of orders,
improper recording of trade information, and prohibited dual trading. As of the end of the target
period, the Exchange was considering offers of settlement submitted by both members calling for
imposition of monetary penalties, suspension of trading privileges, and cease and desist orders.
A final example is Investigation 06-121, in which Compliance staff reviewed TSER prearranged
trading reports to follow up on possible violations detected in the course of a prior investigation.
The investigation resulted in a complaint charging two members with noncompetitive and
prearranged trading, improper cross trading, prohibited dual trading, and fraud or bad faith.*°

The Division is concerned, however, that only three investigations were generated
internally from the Exchange’s TSER exception reports. Since TSER is COMEX’s principal
tool for internally identifying possible trading violations, these reports would be expected to be
the source for a preponderance of the investigations generated by Compliance.*” With the
exception of routine recordkeeping reviews, however, most of the Exchange’s investigations
initiated during the target period were dependent on outside sources. While the Division
recognizes that the low number of investigations generated by Compliance my have resulted in
part from the aftermath of the events of September 11, 2001, and in part from Compliance’s

decision to focus on completing older investigations, the Division nonetheless believes that

38 Subsequent to the target period, the member was fined $4,000 and suspended for one week.
%6 Disciplinary actions are pending in Cases 06-121 and 06-158.

37 In comparison, during the one year target period covered in the Division’s last Rule Enforcement Review of the
Exchange, conducted in 1999, the Exchange opened 46 investigations generated by the Compliance Department.
Thirty-six of those 46 investigations, or 78 percent, resulted from Compliance review of TSER exception reports.

28


B. Trade Practice Surveillance Program: Core Principle (2) - Compliance with Rules,
and Core Principle (12) — Protection of Market Participants

Findings

COMEX generally maintains an adequate trade practice surveillance program through
use of an automated surveillance system, the Trade Surveillance Exception Reporting
System (“TSER”), and floor surveillance to monitor and enforce compliance with
Exchange rules.

Exchange compliance staff routinely review TSER exception reports and trade data
from the Exchange’s Daily Brokerage Recap report for potential trading violations,
and can review and sort all such data online through the Exchange’s Monarch
computer system.

The Exchange closed 44 investigations during the target period, involving possible
trading ahead, prearranged trading, and other noncompetitive trading. Seven of these
investigations resulted in referral of members to the Exchange’s Business Conduct
Committee for disciplinary action, and 16 resulted in issuance of a total of 37 staff
warning letters.

Exchange staff conducted appropriate investigative analyses, and investigations were
thorough and well documented. The Exchange also undertook significant and
successful efforts to close its older investigations and ensure the timeliness of
ongoing investigations.

The Exchange opened 35 investigations during the target period, of which only three
resulted from review of TSER exception reports, the Exchange’s primary surveillance
tool for identifying potential trading violations for further investigation. Ten
investigations were opened in response to complaints and referrals, and 22 were audit
trail reviews. Thus, with the exception of routine recordkeeping reviews, most of the
substantive investigations initiated during the target period were dependent on outside
sources.

The Division is concerned that only three investigations were generated internally
from TSER exception report review, which should be the source of a preponderance
of the Exchange’s investigations. While the low number of internally generated
investigations may have resulted in part from the aftermath of September 11, 2001,
and from an effort to complete older investigations, effective use of TSER should
have generated a larger number of and accounted for a substantial portion of the
Exchange’s investigations.

Recommendations

COMEX should reexamine its program of TSER exception report review, and
make modifications necessary to increase the number of investigations
generated.


II. SUMMARY OF FINDINGS AND RECOMMENDATIONS

A. Audit Trail Program: Core Principle (10) — Trade Information

Findings

COMEX generally maintains an adequate audit trail program which provides for the
recording and safe storage of complete information on all COMEX trades, including
open outcry trades and electronic trades on the ACCESS system, in a manner that
enables use of the information to assist in prevention of customer and market abuses
and to provide evidence of rule violations.

The Exchange’s audit trail enforcement program includes monthly trading card and
bimonthly order ticket reviews, which examine member compliance with
recordkeeping requirements and the accuracy of trade data. Order ticket and trading
card reviews were thorough, well documented, and completed in a timely manner,
and indicated high rates of member compliance with COMEX audit trail
recordkeeping requirements.

COMEX has adequate procedures for reviewing and enforcing compliance with its
trading card recordkeeping requirements, including examination of each member’s
trading cards at least once each year in the course of routine trading card reviews.

The Exchange’s floor order ticket reviews do not provide for sufficient coverage of
the Exchange’s floor broker population. Under its routine bimonthly schedule, the
Exchange reviewed the floor order tickets of only 16 of its approximately 150 floor
brokers during the target period, and its method of selecting brokers for review results
in many brokers’ floor order tickets not being reviewed routinely for an extended
period of time.

Recommendations

COMEX should increase the number of floor brokers reviewed annually in
routine floor order ticket reviews, so that each broker’s floor order tickets are
subject to examination within a reasonable period of time.


bimonthly schedule, the Exchange reviewed the floor order tickets of only 16 of its
approximately 150 floor brokers during the target period. The Exchange’s selection
methodology under this schedule results in many brokers’ floor order tickets not being reviewed
for an extended period of time.

Based on the foregoing, the Division recommends that the Exchange:

e Increase the number of floor brokers reviewed annually in routine floor order ticket
reviews, so that each broker’s floor order tickets are subject to examination within
a reasonable period of time

17


I. AUDIT TRAIL PROGRAM

Core Principle (10) — Trade Information:

The board of trade shall maintain rules and procedures to provide for the recording

and safe storage of all identifying trade information in a manner that enables the

contract market to use the information for purposes of assisting in the prevention of
customer and market abuses and providing evidence of any violations of the rules of
the contract market.

Pursuant to the acceptable practices set forth in Appendix B to Part 38 of the
Commission’s regulations, an effective contract market audit trail should capture and retain
sufficient trade-related information to permit contract market staff to detect trading abuses and to
reconstruct transactions within a reasonable period of time. In addition, the contract market must
create and maintain an electronic transaction history database that contains information with
respect to transactions executed on the designated contract market. An acceptable audit trail also
must be able to track a customer order from time of receipt through fill allocation or other
disposition. Further, an acceptable audit trail should include original source documents,
transaction history, electronic analysis capability and safe storage capability.

Original source documents include unalterable, sequentially identified records on which
trade execution information is originally recorded, whether manually or electronically. A
transaction history consists of an electronic history of each transaction, including all data that are
input into the trade entry or matching system for the transaction to match and clear. These data
should include the categories of participants for whom such trades are executed; timing and
sequencing data adequate to reconstruct trading; and the identification of each account to which
fills are allocated. An electronic analysis capability permits sorting and presenting data included
in the transaction history so as to reconstruct trading and to identify possible trading violations,

and safe storage capability provides for a method of storing the data included in the transaction


analyst each week to spend at least 20 minutes on the COMEX floor during midday.”> In
addition, all Exchange analysts are required to attend either the NYMEX or COMEX closing
period every day.”° Unscheduled floor surveillance is also conducted whenever needed due to
unusual market activity, an anonymous complaint, or an ongoing investigation. Finally, all
analysts are encouraged to perform extra surveillance of the trading floor at random times during
the trading day, especially during busy periods.

The Exchange uses floor surveillance observations to detect violations; determine the
physical location of members relative to other members; determine members’ affiliations with
other members; document various floor trading practices; identify trading patterns that are
unusual for particular members; and deter abuses, such as noncompetitive trading and trading
before the open or after the close. All analysts fill out a Weekly Floor Observation Sheet
detailing their weekly floor surveillance activities. Analysts who observe possible trading
violations while on the floor are required to document their observations immediately in writing.

D. Inquiries and Investigations

When reviews of exception reports, DBRs and specialized reports, or floor surveillance
reveal trading activity which appear to warrant further staff attention but does not yet clearly
indicate a potential violation, Compliance staff undertake what the Exchange calls an inquiry.
All inquiries are recorded in an inquiry log?” Inquiries involve review of additional data

available to the exchange in-house, but do not involve a request for trading cards, order tickets,

?5 Samples of the Compliance Department’s floor observation schedules and memoranda with instructions to staff
are included in Appendix 4.

?6 Since September 11, 2001, COMEX Division gold, silver, and copper futures and options have been trading on a
modified schedule. Effective January 2, 2002, the Exchange resumed the regular opening times for its COMEX
Division. However, these markets have continued to trade on an abbreviated schedule with closing times that are
one hour earlier than they were prior to September 11, 2001.

27 4 copy of the Exchange’s inquiry log can be found in Appendix 5

23



RULE ENFORCEMENT REVIEW OF THE
COMMODITY EXCHANGE, INC. DIVISION
OF THE NEW YORK MERCANTILE
EXCHANGE

% 1975 %

Division of Market Oversight
September 25, 2002


timestamped. ° At present, COMEX ACCESS orders can only be entered by a COMEX member
or member’s employee who qualifies as an Electronic Trader under Exchange rules.'!° ACCESS
automatically records the time of and retains a record of each entry into the system. ACCESS
orders, like floor orders, must contain the price, quantity, commodity, contract month, CTI code,
clearing member, and account designation.'! ACCESS automatically matches orders entered
into its Matching System, and transmits the trade record electronically to the clearing member
firms of the customers on both sides of the trade. ACCESS also automatically records the time
of order entry, trade matching, and any modifications made to an order.

All of the trade data that comprise COMEX’s audit trail, for both open outcry and
ACCESS trades, are contained in the Exchange’s Daily Brokerage Recap report (“DBR”). The
DBR, along with timing and sequencing information from order tickets and trading cards and the
Price Change Register (“PCR” or “time and sales”), allows Exchange staff to adequately
reconstruct transactions within a reasonable period of time. These data also permit staff to track

an order from time of receipt through fill allocation or other disposition.

° See COMEX Rule 6.22. Orders entered immediately into ACCESS may be entered either into the Matching
System or into the Strategy Pad, a database which stores orders, trading strategies, and other information but does
not accept, match or report execution of orders. Orders placed in the Strategy Pad are not matched until released by
the member into the Matching System.

*° See COMEX Rules 11.01, 11.03.
" See COMEX Rule 6.22.

10


opposite floor member and clearing member, the customer type indicator (“CTT”) code,’ and the
date, commodity, future or option, delivery month, quantity, and price. In addition, for option
orders, members must record the strike price, put or call indicator and expiration month.
COMEX Rule 4.80 also requires that trading card entries be made in non-erasable ink, in
chronological order of execution, on sequential lines of the card without skips, and that trades
made during the Exchange’s opening or closing periods be so identified. At COMEX, both
customer and personal trades are recorded on trading cards, such that all trades are sequenced
together.

Floor members must then submit the top ply of each three-ply trading card to the
Exchange within 15 minutes of the end of the half-hour bracket period in which the card has
been used. When the top ply is deposited at the designated collection point, it is timestamped by
Exchange staff, and routed to the floor broker’s primary clearing member (“PCM”), who is
responsible for its retention.* One of the other plies of the trading card is given to the broker’s
clerk, who matches the appropriate order ticket with the trading card and enters the trade
information into the Exchange’s On-Line Trade Entry system (“OLTE”) for clearing. The floor
member is required to maintain the remaining ply of the trading card.

With respect to an order that is to be entered on ACCESS, NYMEX’s electronic trading
system that lists COMEX gold, silver, copper, and aluminum futures for after-hours trading, the

order must either be entered within one minute of receipt or a paper order ticket is created and

7 A CTIis 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 the trader’s
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.

* Each member who executes transactions on the floor must be unconditionally guaranteed by a qualified primary
clearing member. Although under COMEX Rule 4.80(g) members have the option of submitting original trading
cards to their PCMs for timestamping rather than the Exchange, in practice, the vast majority of members submit
their trading cards directly to the Exchange.


investigations had been open for more than one year, including seven that were open for more
than two years.

According to the Exchange, three factors were generally responsible for the length of
time taken in the 12 longest investigations. First, many of these investigations were very fact
intensive and required numerous reconstructions and requests for and review of additional
trading documents. Second, during a number of these investigations Compliance experienced
staff turnover and reductions which resulted in reassignment of some of the investigations to one,
two, or in some cases three different analysts. Third, significant delays resulted from factors
outside normal Exchange operations or Exchange control, including the need for ongoing
response to investigations arising from the trading of gold options on September 28, 1999, and
the impact of the events of September 11, 2001. The Division believes that, in general, these
factors justify the length of time required for completion of the 12 older investigations.

It is also noteworthy that during the target period the Exchange undertook significant and
successful efforts to close the older investigations. Eight of the 12 older investigations were
closed during the target period, and three more were closed within one month after the target
period. Of these 12 older investigations, five (including three of the seven which had been open
for more than two years) were referred to the BCC for disciplinary action, while three resulted in
issuance of Compliance staff warning letters and three were closed with no action taken. One
case related to gold options trading on September 28, 1999 remained open after the target period.
Of the total of 26 investigations open at the beginning of the target period, 22 were closed during

the period, including a total of six that were referred to the BCC.

30


effective use of TSER should have generated a larger number of investigations and accounted for
a substantial portion of the Exchange’s investigations. Therefore, the Exchange should
reexamine its program of TSER exception report review, and make modifications necessary to
increase the number of investigations generated.
F. Timeliness of Investigations

The Exchange monitors the timeliness of investigations through monthly preparation and
supervisory use of the Exchange’s Open Case List, which includes, among other information, the
age of the investigations measured by days open.?® Compliance staff log each investigation
when it is opened, and Compliance administrative staff regularly transfer investigation
information from the log book to the Open Case List, which is maintained in an Excel
spreadsheet. This spreadsheet is sorted by days open to highlight older investigations and track
investigation initiation. At the end of the target period, the Exchange instituted additional
procedures to ensure the timeliness of ongoing investigations. Weekly meetings are now held
between the Associate Director of Compliance and the Compliance managers to review case
loads and establish deadlines for investigation progress. The Associate Director holds follow-up
meetings with the managers concerning these deadlines four weeks after they are established.
According to Compliance staff, these procedures have further improved the Exchange’s overall
investigation timeliness.

The Division found that the Exchange’s investigations were generally completed in a
timely manner. Of the 44 investigations closed during the target period, 73 percent (32
investigations) were completed within one year, including 60 percent (26 investigations)

completed in four months or less. Twenty-seven percent (12 investigations) of the 44 closed

3* Samples of the Open Case List are included in Appendix 7.

29


C. Disciplinary Program: Core Principle (2) - Compliance with Rules
Findings

¢ COMEX maintains an adequate disciplinary program, and handles disciplinary
proceedings in a timely manner. During the target period, the Exchange issued
complaints with reasonable promptness after cases were sent to the BCC, and moved
with reasonable promptness after issuance of complaints to conclude the disciplinary
process and impose sanctions.

e During the target period, the Exchange assessed $44,000 in fines against five
members and imposed suspensions totaling five weeks for trade practice violations
such as noncompetitive trading, prearranged trading, and trading against customer
orders. In addition, three members were ordered to pay a total of $26,931.10 in
restitution to customers. Penalties imposed appeared reasonable relative to the
conduct being sanctioned, and appear sufficient to deter future similar violations.

Recommendations

Based on the foregoing, the Division has no recommendations at this time with respect to
the Exchange’s disciplinary program.


each of the various managers. All Compliance staff assignments include cases from both the
NYMEX and COMEX Divisions of the Exchange.

The Division believes that the Exchange’s current Compliance staffing levels are
sufficient to enable the Exchange to maintain adequate trade practice surveillance and
disciplinary programs

B. Automated Trade Practice Surveillance

The Exchange’s core trade practice surveillance program consists of routine reviews of
exception reports generated by the Exchange’s automated trade practice surveillance system, the
Trade Surveillance Exception Reporting System (“TSER”), and manual reviews of the DBR and
specialized surveillance reports. Each of these reports and the PCR are available to Compliance
Department staff on-line through the Exchange’s Monarch computer system, implemented in
1999. Monarch allows analysts to view all pertinent surveillance reports on their desktop
computers and to sort the data in spreadsheets. The ability to view and sort data on-line
enhances the volume of trade information available for analysts’ review. The Monarch system
can retrieve data on all trades from October 1999 to the present. As stated earlier, data for
previous years is available through hard copies of electronic tape and microfiche backup.

The TSER system generates several daily exception 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. The reports cover all
Exchange trades, whether made via open outcry or the ACCESS electronic trading system.
Compliance staff can modify report parameters 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

20



each charge or penalty reviewed. The Appeals Panel’s decision constitutes the final decision of
the Exchange, and takes effect 15 days after delivery to the respondent and the Commission.”
C. Timeliness of Disciplinary Procedures

To assess the timeliness of Exchange disciplinary procedures, the Division reviewed the
COMEX Trade Practice Investigation Log and Final Disciplinary Actions Log for the target
period, the minutes of Exchange disciplinary committees, and al] related Exchange disciplinary
files.*

During the target period, Compliance forwarded seven cases to the BCC for disciplinary
action. The Division found that the Exchange generally issued complaints with reasonable
promptness after cases were sent to the BCC. As noted above, the COMEX Panel of the BCC
meets on a bimonthly basis, in alternation with the NYMEX Panel, although special meetings are
called when necessary. Complaints were issued within two months after Cases 04-207 and 03-
204 were sent to the BCC. In Cases 06-110, 06-121, and 02-149, complaints were delayed by
the events of September 11, 2001, but were issued within three to five months. In Case 06-065, a
complaint was issued six months after the matter was sent to the BCC, due to a normal
postponement request by the respondent member for the purpose of retaining counsel and
making a settlement offer. Final disciplinary action in that case included payment of a $4,000
fine and a one week suspension. In Case 06-158, the BCC voted to issue a complaint one month
after receiving the case, but issuance of the complaint was delayed for six months due to the
events of September 11, 2001, and the complex nature of the 22 separate counts involved. The
case is currently scheduled for an adjudicatory hearing, and the Exchange is considering a

settlement offer from the respondent member.

* See Disciplinary Rules 8.16, 8.17, 8.18, 8.19, and 8.20.
$3 A copy of the COMEX Final Disciplinary Actions Log is attached as Appendix 8.

37


The Division also found that the Exchange moved with reasonable promptness after
issuance of complaints to conclude the disciplinary process and impose sanctions. During the
target period, the Exchange brought five disciplinary cases to a final conclusion, including four
cases forwarded to the BCC prior to the beginning of the target period and once case sent to the
BCC during the target period.TM’ In three of these cases, disciplinary action including imposition
of sanctions was concluded within three to nine months after complaints were issued.°> The
remaining two cases were concluded by issuance of BCC warning letters one to five months after
the cases were sent to the BCC.**

’ D. Sanctions Imposed

To assess the penalties imposed by the Exchange, the Division reviewed the Exchange
Final Disciplinary Actions Log and Exchange disciplinary committee minutes, Regulation 9.11
disciplinary action notices reflecting disciplinary actions taken during the target period, and all
related Exchange disciplinary files. As noted above, during the target period, the Exchange
brought five disciplinary cases to a final conclusion. In these cases, the Exchange imposed fines
totaling $44,000 against five members for violations of trade practice, recordkeeping, financial,
and conduct rules. In addition, the Exchange suspended two members for a total of five weeks,
issued three BCC warning letters to three members and one member firm, and ordered three

members to pay restitution totaling $26,931.10 to disadvantaged customers.°”

** The four cases sent to the BCC prior to the beginning of the target period and concluded during the target period
were Cases 06-045, 04-176, F-02, and 06-174. Case 04-207 was both sent to the BCC and brought to a final
conclusion during the target period.

* These cases included Cases 06-045, F-02, and 04-207.

56 Case 04-176 was concluded with a BCC warning letter to a floor broker for failure to properly report cross trades,
and Case 06-174 was concluded with a warning letter to a member firm for failure to properly timestamp branch
office order tickets.

*” Restitution to disadvantaged customers was ordered in Case No. F-02 in the amount of $23,781.10, and was
ordered in case No. 06-045 in the amount of $3,150.

38


target period investigation files, and found that they contained appropriate information and
decision rationales.

If the Director or Associate Director of Compliance determine that disciplinary action is
warranted, the analyst prepares a more detailed investigation report under the supervision of his
or her manager, describing the steps taken in the investigation, the facts developed, the analyses
conducted, and the staff’s conclusions and recommendations. While preparing the report, the
analyst or manager may consult with the Director or Associate Director, the Compliance
Counsel, or the Vice President of Compliance concerning significant issues involved in the
matter. After the report is signed by the analyst and his or her manager, and approved and signed
by either the Director or Associate Director and by Compliance Counsel, it receives final review
and approval by the Vice President of Compliance. For cases referred to the BCC, the date of
the Vice President’s approval is the date the investigation is considered closed. During the target
period, the Exchange undertook efforts to expedite preparation of investigation reports, without
reducing the level of detail requested by the BCC, through increased use of document scanning
and more concise descriptions of the trading activity at issue.

E. Adequacy of Investigations

During the target period, Compliance staff opened 35 investigations. Three
investigations resulted from review of TSER exception reports, two involving possible
prearranged trading and one involving possible wash trades.*! Ten investigations were opened in
response to complaints and referrals, including four member complaints, two customer
complaints, one anonymous complaint, one floor committee referral, one referral from the

National Futures Association, and one from the Exchange’s legal department. The remaining

3! The prearranged trading Investigations were No. 06-206 and No. 06-240; the wash trading investigation was No.
06-222. Investigation No. 06-206 was closed during the target period without disciplinary action. Investigations
No. 06-240 and 06-222 remained open at the conclusion of the target period.

26


Appendix B to Part 38 provides guidance and acceptable practices concerning the core principles
with which a designated contract market must comply to maintain its designation. Although the
guidance establishes non-exclusive safe harbors, it does not establish mandatory means of
compliance with the core principles.

This review focuses on three core principles that relate to COMEX’s audit trail, trade
practice surveillance, and disciplinary programs. Core Principle (2) - Compliance with Rules,
and Core Principle (12) - Protection of Market Participants, address surveillance, enforcement,
and disciplinary procedures used by an exchange to protect market participants from abusive
trading practices. Core Principle (10) — Trade Information, relates to maintenance of an audit
trail that can be used to assist an exchange in the identification and prosecution of customer and
market abuses. Although Appendix B to Part 38 provides acceptable practices for demonstrating
compliance with Core Principles 2 and 10, acceptable practices are not described for Core
Principle 12.4 Thus, no safe harbor has been established for that core principle.

For purposes of this review, Division staff interviewed officials and staff from the
Exchange’s Compliance Department (“Compliance”).° The Division also reviewed numerous
documents used by Compliance in carrying out the Exchange’s routine oversight responsibilities.

These documents included, among other things, the following:

¢ computer reports generated by COMEX’s automated surveillance systems and
other documents used in trade practice surveillance;

e trade practice investigation and disciplinary case logs;

* The Commission has reserved the authority to adopt acceptable practices for compliance with Core Principle 12 at
a later date.

> A copy of the April 17, 2002 transcript of those interviews can be found in Appendix 1.


654 trading cards per month. These reviews resulted in 248 Full Compliance letters, 38
Effective Compliance letters, and three warning letters. Two brokers were re-reviewed, with one
determined to be in full compliance and one to be in effective compliance. The Division found
that the Exchange’s trading card reviews were thorough, well-documented, and completed in a
timely manner.

The Division believes that COMEX has adequate procedures for reviewing and enforcing
compliance with its trading card recordkeeping requirements.

2. Order Ticket Reviews

Compliance conducts order ticket reviews on a bimonthly basis. A supervisor or
manager selects one of the approximately 70 broker groups at the Exchange for review, which
includes examination of both floor order tickets and branch office order tickets. Broker groups
may be selected for inclusion in an order ticket review based on the appearance of order tickets
of their members which have been examined during the course of Exchange trade practice
investigations.

In a floor order ticket review, Compliance staff examine a minimum of 30 orders from a
day (or days) on which the selected broker group had significant trading volume. If Compliance
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. Ifa single day’s
business or the activity in a single commodity is insufficient to provide the minimum required
sample, additional trade dates or commodities are selected. A Compliance analyst examines
each order ticket for the required account identification information and timestamps.'* As an

adjunct to the review, selected order tickets for filled orders also are matched to the

'® The Exchange considers a customer’s account number or a unique code traceable to that account an acceptable
account identifier. All filled or partially filled orders are required to have entry and exit timestamps, while unfilled
or canceled orders are required to have at least an entry timestamp.

13


appropriate account identification, timestamps, and order terms that corresponded to the
associated floor order tickets.””

The Division’s review of the Exchange’s order ticket reviews indicates that the reviews
were thorough, well documented and completed in a timely manner. However, the Division
believes that the Exchange’s routine bimonthly floor order ticket review does not provide for
sufficient coverage of the Exchange’s floor broker population. During the target period, the
Exchange reviewed the floor order tickets of a total of only 16 of its approximately 150 floor
brokers. Although the Division recognizes that the Exchange also reviews orders that are
received during the course of an investigation, the current methodology results in many brokers
not being subject to a routine floor order ticket review for an extended period of time. It is
important to conduct floor order ticket reviews on a routine basis not only because this may
reveal recordkeeping deficiencies, but also, and more importantly, because doing so may identify
irregularities on the face of an order that may underlie more substantive violations, such as
alteration of an account number to allocate fills to a favored account. Therefore, the Exchange
should increase the number of floor brokers it reviews on an annual basis, so that each broker’s
floor order tickets are routinely subject to examination within a reasonable period of time.

C. Safe Storage Capability

As stated above, COMEX’s DBR report contains complete trade information for all

trades executed on COMEX, including open outcry trades and electronic trades on the ACCESS

system. The DBR is created and maintained on the COMEX IBM mainframe computer, on

7° In one branch office order ticket review, Compliance noted that the order tickets were timestamped when the
order was transmitted to the trading floor, but that the branch office order tickets were consistently timestamped
between one to three minutes later than the corresponding “in” timestamps on the floor order tickets. Compliance
concluded that the discrepancy probably resulted from the fact that the timestamp clocks in the branch office may
not have been set to the correct time according to the national atomic clock, and issued an appropriate
Warning/Advisory letter. In addition, as a result of this review members of a floor group were issued Warning
Letters for failing to register as a Broker Association as required under Exchange Rule 6.43(d).

15


RULE ENFORCEMENT REVIEW OF THE
COMMODITY EXCHANGE, INC. DIVISION OF THE
NEW YORK MERCANTILE EXCHANGE

I. INTRODUCTION: PURPOSE AND SCOPE

The Division of Market Oversight (“Division”) has completed a rule enforcement review
of the audit trail, trade practice surveillance, and disciplinary programs of the Commodity
Exchange, Inc. Division (“COMEX” or “Exchange”) of the New York Mercantile Exchange
(“NYMEX”) for compliance with applicable provisions of Section 5(d) of the Commodity
Exchange Act (“Act”), as amended by the Commodity Futures Modernization Act of 2000
(“CFMA”), and Part 38 of the Commission’s regulations. The review covers the target period of
January 1 through December 31, 2001.!

The CFMA, which became effective on December 21, 2000, replaced prescriptive rules
with broad, flexible core principles that are applicable to, among other trading facilities,

»? On August 10, 2001, the Commission published final rules,

“designated contract markets.
effective October 9, 2001, which implemented the CFMA with respect to trading facilities? The

final Part 38 rules include acceptable practices for satisfying the core principles. Specifically,

' 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 investigation and disciplinary case files, 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.

? Section 5(c) of the Act provides that a board of trade, such as COMEX, that was a designated contract market on
the date of the enactment of the CFMA shall be considered to be a designated contract market under the Act.

° See 66 F.R. 42255


days after receipt of the admission or failure to deny. If the respondent has submitted an answer
denying the charges, and has waived a hearing, the Hearing Panel must make its decision based
on the documents filed by Compliance and the respondent, and render a written decision in the
same manner as if a hearing had been conducted.”

If a disciplinary matter proceeds to a hearing, the Hearing Panel 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 their effective date. The sanctions that the Hearing Panel may impose are the same
as those which may be included in a Hearing Panel settlement agreement as discussed above.
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.”!

In the event of an appeal, the Appeals Committee Chairman appoints and Appeals Panel
to hear and decide the appeal. 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 record of the Adjudicative Committee proceedings. The Appeals Panel may affirm, reverse,
or modify the Hearing Panel’s decision, but may not set aside the Hearing Panel’s findings of
tule violations if those findings are supported by the record. The Appeals Panel’s written

decision must include, among other things, a statement of findings and conclusions regarding

*° See Disciplinary Rule 8.11.
3 See Disciplinary Rules 8.12(A) and 8.13.

36


or other documentation available only through a request to a member or PCM. Additional in-
house data reviewed may include DBR data for previous or subsequent dates, further exception
reports, or additional floor surveillance. An inquiry is not a prerequisite for an investigation, and
Compliance staff can open an investigation directly following exception report review if they
believe one is warranted.

If Compliance staff conclude after conducting an inquiry that there is insufficient reason
to proceed to a formal investigation, they prepare a short inquiry memorandum noting the
reasons for and the results of the inquiry. An inquiry file is then created, and the memorandum is
retained in the file along with copies of any documents reviewed in the course of the inquiry. If
staff conclude that a formal investigation is warranted, the inquiry is closed and an investigation
is opened.”

When an investigation is opened, whether resulting from an inquiry, as described above,
or directly from routine surveillance or external sources, an investigation number and an analyst
and supervisor are assigned, and the matter is entered into a separate investigation log. For each
investigation, the log records the date the investigation was opened, the member(s) being
investigated, the nature of the investigation, and the identity of the assigned analyst.”” At the
start of an investigation, Compliance staff request trading cards, order tickets, and other
underlying documentation from the members and PCMs involved by sending a form letter,
which is hand delivered, mailed, or faxed, or accepted in the Compliance office by the addressee

or his or her designee. In either instance, the recipient signs a copy of the letter to acknowledge

?5 Compliance completed 18 of 19 inquiries opened during the target period, none of which evolved into an
investigation. The 19 inquiries included three generated from TSER reports, three from DBR review, and seven
from review of out trade and trade correction reports. In addition, one inquiry resulted from floor surveillance and
five were opened in connection with member complaints. One inquiry resulted in the issuance of a staff warning
letter to a member for improper execution of discretionary orders.

?> A copy of the investigation log can be found in Appendix 6.

24



TABLE OF CONTENTS

I. INTRODUCTION: PURPOSE AND SCOPE.....0...:cccssscssssssstesessesssiesessessnssneneeeees 1

Il. SUMMARY OF FINDINGS AND RECOMMENDATIONS 4
A. Audit Trail Program: Core Principle (10) — Trade Information.. a4

B. Trade Practice Surveillance Program: Core Principle (2) — Compliance with Rules, . 5

5

6

and Core Principle (12) — Protection of Market Participants.
C. Disciplinary Program: Core Principle (2) - Compliance with Rules.

I. AUDIT TRAIL PROGRAM
A. Exchange Order Flow and Recordkeeping Procedures.

B. Audit Trail Reviews..........

1. Trading Card Reviews

2. Order Ticket Reviews

C. Safe Storage Capability...

D. Conclusions and Recommendations

IV. TRADE PRACTICE SURVEILLANCE PROGRAM ..
. Compliance Staff...
. Automated Trade Practice Surveillance...
. Floor Surveillance ..
. Inquiries and Investigations ..
. Adequacy of Investigations

Timeliness of Investigations ..
. Conclusions and Recommendations

QTMmMUAD>

V. DISCIPLINARY PROGRAM.
A. Disciplinary Committees...
B. Disciplinary Procedures ....
C. Timeliness of Disciplinary Procedures
D. Sanctions Imposed ............000s08
E. Conclusions and Recommendations.


V. DISCIPLINARY PROGRAM

As stated earlier, Core Principle 2 requires, among other things, that an Exchange have
the authority to discipline, suspend, or terminate the activities of members or market participants
pursuant to clear and fair standards. In this regard, an acceptable program should provide for
prompt and effective disciplinary action for any violation that is found to have been committed.

A. Disciplinary Committees

The COMEX and NYMEX divisions of the Exchange are subject to the same disciplinary
tules, and to the jurisdiction of the same disciplinary committees, which are divided into separate
COMEX and NYMEX panels. Unless otherwise noted, references to panels of disciplinary
committees in this report refer to the appropriate COMEX panel.

COMEX has three principal disciplinary committees: the BCC, the Adjudication
Committee, and the Appeals Committee. In addition, the Floor Committee has authority to
enforce recordkeeping, clerk registration, decorum, and similar administrative rules through
imposition of summary fines as provided in the Exchange’s summary fine schedules.°®

The BCC is responsible for determining whether a member should be prosecuted for
violations of Exchange or Commission rules, and is authorized to enter into settlement
agreements in conjunction with initiation of disciplinary proceedings. The COMEX panel of the
BCC consists of a Chairman, who is a NYMEX Division member, a Vice Chairman who is a

COMEX member, nine regular committee members, and four alternates.’°

%° See Exchange Rules 8.21, 8.22.

“° Disciplinary Rule 3.13 requires that the COMEX Panel of the BCC be comprised of 70 percent COMEX members
and 30 percent NYMEX members. The nule further requires that the nine members include at least one person who
is neither an Exchange member nor a member’s employee. The remaining Panel members are to include floor
brokers, locals, traders, and FCMs.

32




investigations on the Exchange’s log were the 11 trading card reviews, six floor order ticket
reviews, and five branch office order ticket reviews conducted during the target period.

Compliance also closed 44 investigations during the target period. These involved
possible trading ahead, prearranged trading, and other noncompetitive trading, as well as
customer, member and anonymous complaints. Seven of the 44 investigations resulted in the
referral of members to the BCC for disciplinary action.” Sixteen of the 44 investigations
resulted in the issuance of a total of 37 staff warning letters, covering offenses ranging from
violation of Exchange rules prohibiting prearranged trading and improper cross trades to failure
by members to provide records, properly timestamp orders, or register with the Exchange as
broker associations.

The Division reviewed all 44 investigations closed during the target period, including two
which had been referred to the Exchange by the Division.’ The Division found that Exchange
staff conducted appropriate investigative analyses and that investigations were thorough and well
documented.** For example, in Investigation No. 06-065, Compliance followed up on a lead
provided by the trading ahead TSER report. Compliance reviewed all relevant trading
documents, reconstructed the trading activity involved, and interviewed all relevant witnesses.
Although no trading ahead was found, the investigation resulted in issuance of a complaint

alleging violations including crossing of orders, misallocation of trades, creation of fictitious

* The Exchange’s disciplinary program is discussed below at pages 32-40.

One of the Division’s referrals, Investigation No. 06-199, resulted in the issuance of staff warning letters to three
members for violation of Exchange Rule 4.24(d), “Prohibited Cross Trades.” The other Division referral,
Investigation No. 02-149, resulted from a customer complaint regarding a bad fill price he received on one order and
an unfilled order placed in the gold futures market on trade date September 28, 1999. The investigation was
expanded to include other alleged trading abuses, and the matter has been referred to the BCC for disciplinary
action.

** Each of the investigation files contained relevant documentation, including copies of trading cards, order tickets,
computerized exception reports, DBRs, PCRs, and correspondence. In addition, interviews of subject members
were tape recorded and the tapes were included in investigation files. Where interview tapes were transcribed,
transcript copies were also included in investigation files.

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B. Audit Trail Reviews

To assess compliance with COMEX Rules 4.80 and 4.81, the Exchange conducts routine
reviews of trading cards and order tickets.

1. Trading Card Reviews

The Exchange conducts trading card reviews each month, and in the course of those
reviews examines every member’s trading cards at least once each year. Each monthly review
includes approximately one twelfth of the Exchange’s members, as selected by Compliance staff
from the master Exchange membership list. Members are added to the monthly review
whenever the Exchange’s Broker vs. Price Change Register Time Comparison Report (“Broker
vs. PCR Report”)? or Broker vs. Broker Report”? reveal that they may have failed to record trade
execution times properly on their trading cards. In addition, members are added if they failed
any element of a previous trading card review.'*

Compliance staff typically examines up to 30 trading cards of each member, drawn from
three dates during the month selected by Compliance staff for the review. If a member did not
use at least 10 trading cards over the three selected dates, additional cards used by that member
on an additional date or dates during the month are also examined. Compliance staff also review
the trading cards of a subset of the members included in each trading card review to monitor

compliance with the requirement that the original top ply of each trading card be submitted to the

” 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.

3 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.

' Such members are re-reviewed within two to three months. In a re-review, the member’s trading cards are
examined for compliance with all trading card requirements, not merely those with respect to which the member
previously failed to comply.

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corresponding trades on the executing broker’s trading cards, which are requested as part of the
order ticket review, to determine if the broker’s manually recorded execution times on the card
are consistent with the order ticket’s entry and exit timestamps.

When the floor order ticket review is completed, Compliance conducts a branch office
order ticket review. A Compliance analyst examines office orders of one futures commission
merchant (“FCM”) for whom the selected broker group filled orders.'? Ten to 15 of the FCM’s
branch office order tickets are reviewed for the presence of account identification, order number,
and a timestamp representing the time of order receipt from the customer. For option orders, the
analyst also verifies the presence of a timestamp reflecting the time of order entry. Further, the
analyst examines the timestamps on the office order tickets to verify that they are
chronologically consistent with trading card times and time and sales prints, and compares the
account identifiers on the floor and office order tickets to confirm that they identify the same
customer. Similar to trading card reviews, Compliance staff will also follow up on other types of
possible violations discovered during the course of floor and branch order ticket reviews.

The Exchange completed six floor order ticket reviews during the target period,
examining a total of 216 floor order tickets from a total of 16 floor brokers. The Exchange found
that virtually all (215 of the 216 order tickets examined) contained account identification, and
93% (201 of the 216 order tickets) contained required timestamps. As a result of the six floor
order ticket reviews, one broker group was issued a Compliance warning letter for failure to
properly time stamp floor order tickets. The Exchange completed five branch office order ticket

reviews during the target period, examining a total of 50 office order tickets, all of which had

”° In those rare cases where the floor order ticket review does not suggest an appropriate FCM for the branch office
order ticket review, an FCM not recently reviewed is selected at random.

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