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From Securities Regulation Daily, April 18, 2019

FXCM was simply surprised by Swiss Franc de-pegging

By Rodney F. Tonkovic, J.D.

A large currency movement was a black swan event, and a retail foreign exchange broker holding a large position was simply blindsided.

In a summary order, a Second Circuit panel affirmed a district court judgment dismissing a fraud suit claiming that a foreign exchange dealer lied about its business model before the 2015 Swiss franc "flash crash." Investors contended that FXCM, Inc. was reckless in holding a large position in the Swiss Franc that led to substantial losses after the Franc was unexpectedly de-pegged from the Euro in early 2015. The panel affirmed the district court's conclusion that the more compelling inference was that FXCM didn't see the de-pegging as a serious risk at the time and also failed to foresee the consequences (Retirement Board of the Policemen's Annuity and Benefit Fund of Chicago v. FXCM Inc., April 17, 2019).

FXCM. The action was brought by an institutional investor in FXCM Inc., a brokerage firm that gave retail customers access to the retail foreign exchange market. Unlike most retail brokers, FXCM used an "agency model" for its operations, meaning that it served as an intermediary by contracting with liquidity providers on behalf of its customers. Under its agreement with its customers, in the event of a loss, a customer was responsible only for the amount of collateral posted, and FXCM was pay the excess loss. As a safeguard, FXCM would close out a customer's position if changes in currency prices exhausted that customer's collateral.

Swiss Franc de-pegged. The value of the Swiss Franc had been pegged to the Euro since 2011, and in January 2015, FXCM's customers held a $2.2 billion position in the Euro/Swiss Franc ("EUR/CHF") currency pair. On January 15, 2015, the Swiss National Bank, with no warning, announced that it was no longer pegging the Swiss Franc to the Euro. As a result, the value of the Swiss Franc abruptly rose in relation to the Euro, and caused FXCM customers to suffer losses well above their collateral. FXCM ultimately lost $276 million.

The investor alleged that FXCM made a number of false or misleading statements about the risks associated with FXCM’s business model, especially with respect to the risks associated with FXCM’s leverage policies and the firm's exposure to massive losses if the Euro were de-pegged from the Swiss Franc. The first amended complaintwas dismissed in August 2016 after the district court concluded that the fund failed to plead scienter with the required specificity; it was just as plausible, the court said, that FXCM was blindsided by the de-pegging. In August 2018, the district court dismissed the second amended complaint, again finding that the plaintiffs failed to adequately allege either scienter or a material misrepresentation.

No scienter. On appeal, the panel concluded that the investor failed to allege facts amounting to a strong inference of scienter and accordingly affirmed the district court's dismissal. The investor's arguments centered on FXCM's CEO's alleged false descriptions of the risks inherent in FXCM's business and the risk the firm took in holding a large position in the EUR/CHF pair.

The panel said that the allegations about FXCM's representations of its business model were no more than fraud by hindsight. In this case, the de-pegging and its consequences were deemed by the market in general to be a "black swan-like" event. And, while the panel agreed with the investor that FXCM must have known that the peg of the Franc to the Euro was not permanent, it disagreed that FXCM could predict the magnitude of the consequences. The investor asserted that it was reckless for the firm not to disclose its $2.2 billion position, but the more compelling inference, the panel said, was that the CEO did not see a credible risk that the Franc would be de-pegged at that time and thus saw no need to disclose FXCM's large position on the EUR/CHR pair. And, the firm had weathered smaller currency movements before.

Lastly, the investor also alleged that FXCM tried to cover up the extent of the loss following the de-pegging. Here, the plaintiff pointed to alleged contradictions in statements in emails and to the CFTC about the sort of losses FXCM suffered and whether it experienced liquidity failures. If these statements were even contradictory (the district court said they might not be), the panel found that this did not make it more likely that before January 15, 2015, the CEO thought that there was a serious risk of de-pegging and lied about that risk.

The case is No. 18-2604-cv.

Attorneys: Deborah Clark-Weintraub (Scott & Cain, Attorneys at Law) for Retirement Board of the Policemen’s Annuity and Benefit Fund of Chicago. Paul R. Bessette (King & Spalding LLP) for FXCM Inc.

Companies: FXCM Inc.

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