Has the Law of Manipulation Lost Its Moorings?

Law360, New York (April 7, 2017, 3:50 PM EDT) -- As regulations have multiplied and Congress has conferred additional authority on the U.S. Commodity Futures Trading Commission, the power of the CFTC's Division of Enforcement (DOE) has grown significantly. For many years, CFTC enforcement focused on intent-based wrongdoing, such as fraud and trade practice violations. However, new authority to pursue disruptive trading practices, nonscienter-based fraud for swap dealers, reporting violations and that old favorite, failure to supervise, have empowered the DOE and enhanced its ability to influence policy as well as punish for violations of the Commodity Exchange Act, even when the violators lack wrongful intent. With these new powers comes a responsibility to act with restraint and sensitivity to the potential adverse impact that the DOE's conduct has on the market and market participants – a restraint that sometimes seems at odds with the hyperaggressiveness that the DOE has exhibited in recent years.

Nowhere have these trends been more evident than in the developing law of manipulation. Combating market manipulation has been at the core of derivatives regulation since its origins.¹ It has long been a felony under the Commodity Exchange Act for "any person to manipulate or attempt to manipulate the price of any commodity in interstate commerce or for future delivery."² While the Commodity Exchange Act and its regulations do not contain a definition of manipulation, the courts have traditionally identified two essential elements: a specific intent to manipulate and some act or conduct by the manipulator that actually causes an artificial price, i.e. a price that does not reflect the legitimate forces of supply and demand.³

Intent had always been viewed as key to defining manipulation, since, absent conduct that is fraudulent or by its very nature price-distorting, "it is the intent of the parties which separates otherwise lawful business conduct from unlawful manipulative activity," as the CFTC itself has recognized.⁴ Likewise, the creation of an artificial price is an essential element of a crime that by its terms seeks to prevent price manipulation and to protect market users and society from the impact of prices that do not reflect the fundamental forces of supply and demand.

While specific intent and the existence of artificial prices formed the bedrock of any manipulation case, the DOE and commentators often complained about the difficulty of proving these two elements. The DOE complained that absent a defendant's admission, direct evidence of intent was rarely available. In addition, establishing that market prices did not reflect the legitimate forces of supply and demand often required detailed economic analysis that was expensive and rarely uncontested. These complaints about the difficulty of proving manipulation were hardly surprising given the central role that the detection and punishment of manipulation played at the CFTC.

However, a healthy skepticism toward these complaints is also appropriate. Most crime in the U.S. requires proof of intent. Prosecutors, plaintiffs, judges and juries are hardly unfamiliar with the burden of proving intent or the myriad of ways that wrongful intent can be established with either direct or circumstantial evidence. Indeed, with the emergence of email, texting, tape recording and social media, gathering evidence of intent has never been easier. Nor should it come as a great shock that a crime that involves whether market price has been distorted will require some economic analysis. You rarely hear antitrust lawyers complain that bringing an antitrust claim requires economic analysis. Yet for many manipulation cases, understanding the economic fundamentals and market dynamics are no less important and should not be avoided.

While manipulation law remained relatively static for many years, the western U.S. power crisis at the beginning of this century and the global financial crisis of 2007-2008 created the impetus to provide enhanced anti-manipulation authority to the CFTC and other regulators. Specifically, the Dodd Frank Act amended Section 6(c) of the Commodity Exchange Act to expand the CFTC's authority over fraud-based manipulation. Congress borrowed from Section 10(b) of the Securities and Exchange Act of 1934 to provide the CFTC with a new anti-manipulation provision. Section 6(c)(1) provides in relevant part:

Prohibition Against Manipulation It shall be unlawful for any person, directly or indirectly, to use or employ, or attempt to use or employ, in connection with any swap, or a contract of sale of any commodity in interstate commerce, or for future delivery on or subject to the rules of any registered entity, any manipulative or deceptive device or contrivance, in contravention of such rules and regulations as the Commission shall promulgate.

In 2011, the CFTC implemented amended Section 6(c) by promulgating Rule 180.1. The commission adopted language similar to the U.S. Securities and Exchange Commission's Rule 10(b)(5). Rule 180.1 provides:

§ 180.1 Prohibition on the employment, or attempted employment, of manipulative and deceptive devices.

(a) It shall be unlawful for any person, directly or indirectly, in connection with any swap, or contract of sale of any commodity in interstate commerce, or contract for future delivery on or subject to the rules of any registered entity, to intentionally or recklessly:

(1) Use or employ, or attempt to use or employ, any manipulative device, scheme, or artifice to defraud;

(2) Make, or attempt to make, any untrue or misleading statement of a material fact or to omit to state a material fact necessary in order to make the statements made not untrue or misleading;

(3) Engage, or attempt to engage, in any act, practice, or course of business, which operates or would operate as a fraud or deceit upon any person; or,

(4) Deliver or cause to be delivered, or attempt to deliver or cause to be delivered, for transmission through the mails or interstate commerce, by any means of communication whatsoever, a false or misleading or inaccurate report concerning crop or market information or conditions that affect or tend to affect the price of any commodity in interstate commerce, knowing, or acting in reckless disregard of the fact that such report is false, misleading or inaccurate. Notwithstanding the foregoing, no violation of this subsection shall exist where the person mistakenly transmits, in good faith, false or misleading or inaccurate information to a price reporting service.

The commission described its new rule this way:

As discussed below, final Rule 180.1 implements the provisions of CEA section 6(c)(1) by prohibiting, among other things, manipulative and deceptive devices, i.e. fraud and fraud-based manipulative devices and contrivances employed intentionally or recklessly, regardless of whether the conduct in question was intended to create or did create an artificial price.

In one fell swoop, the CFTC had discarded both the intent and artificial price elements of the manipulation offense. Any scienter based fraud would do – whether willful or reckless. And the conduct need not have created an artificial price nor have intended to do so. The commission's rule-making did not explain what the difference was between fraud and manipulation under Rule 180.1 or whether every fraud involving a commodity in interstate commerce (i.e. just about everything but onions and motion picture receipts) or a commodity derivative was now also a manipulation and subject to new enhanced penalties.

Perhaps more troubling, the commission declined to clearly limit Rule 180.1 to fraud-based manipulations despite the request of a number of commenters.⁵ This was important because the elimination of the intent requirement could arguably be justified when the manipulation involves fraud or the injection of false information into the market. When fraud is used to impact price, there is little reason to be concerned that lawful and beneficial market trading behavior will be confused with illicit manipulative activity. Similarly, while it is difficult to understand how manipulation can occur without an impact on market price, one could argue that when fraud is present, it is not unreasonable as a prophylactic measure to presume market impact. A presumption of market impact in the case of fraud would be akin to the "fraud on the market" doctrine adopted under the securities laws. However, even in the case of fraud, a rebuttable presumption of market impact would be preferable to eliminating entirely the requirement that the alleged manipulator caused an artificial price. In any event, at least with regard to fraud-based manipulations, the elimination of a specific intent requirement and the need to find an artificial price under Rule 180.1 would not leave the rule wholly devoid of standards, since the elements of fraud would still have to be established. The same cannot be said for market conduct where fraud is not present.

While DOE officials assured the industry at the time of the Rule 180.1 rule-making that the rule would apply only to fraud-based manipulations, the temptation to jettison the traditional elements of manipulation for all cases proved too tempting.

The first such expansion occurred in 2013, when the CFTC settled with JPMorgan Chase Bank in the so-called "London whale" case.⁶ According to the settlement order in that case, traders in the bank's London branch sought to reduce mark-to-market losses in its credit default swap portfolio ahead of month-end internal portfolio valuations by selling a record volume of swaps at month end. The commission found that JPMorgan Chase had recklessly employed a manipulative device or contrivance in violation of Rule 180.1. The order noted that the bank’s traders recognized that the sheer size of their position in the market "had the potential to affect or influence the market" but nevertheless sold massive amounts of protection during a concentrated period in order to "defend" its position in the market. The manipulative device was described succinctly in the settlement order as selling enormous volumes of swaps in a very short period at month end. While traders at the bank apparently misled their supervisors, there was no allegation that the bank's aggressive trading strategy involved fraud on market participants or any underlying misrepresentations. Significantly, the commission did not find that the bank intended to manipulate prices; rather the order claimed that the bank's strategy was reckless. The order also did not find that the bank's trading created an artificial price or intended to do so. In fact, the order explicitly stated that under Rule 180.1 such a finding is unnecessary because the bank's conduct "interfered with the free and open markets."⁷

This new standard – if you can call it that – appears to be borrowed from the anti-manipulation rule adopted by the Federal Energy Regulatory Commission in 2006. The FERC's anti-manipulation rule was also based on the SEC's Rule 10(b)(5). While admitting that its manipulation authority was limited to fraud, FERC, in its rule-making announcing its new anti-manipulation authority, remarkably ignored 100-plus years of case law requiring the existence of a material misrepresentation or omission and instead defined fraud as follows:

The final rule prohibits the use or employment of any device, scheme or artifice to defraud. The Commission defines fraud generally, that is, to include any action, transaction or conspiracy for the purpose of impairing, obstructing or defeating a well functioning market.⁸

The CFTC's new and disturbing expansion of Rule 180.1 to encompass nonfraud based manipulations can be seen in the recent case brought by the commission against Kraft Foods

and Modelez Global LLC.⁹ In that case, the CFTC alleges that Kraft manipulated the wheat market by purchasing and maintaining a large position in wheat futures in an attempt to drive down the cost of physical wheat that Kraft needed to purchase for its business. The CFTC's complaint included a claim under both Section 9(a)(2) (the traditional manipulation standard) and Rule 180.1. The defendants moved to dismiss the Rule 180.1 claim on the ground that the rule only prohibited fraud and fraud-based manipulations and that Kraft's open purchase of futures positions was not fraudulent. The CFTC argued that a "anipulative device" under Rule 180.1 did not require a finding of fraud. The district court disagreed and held that Rule 180.1 applies only to fraud and fraud-based manipulations. But the court went on to deny the defendants' motion to dismiss on the ground that the CFTC's complaint adequately alleged that Kraft committed fraud and deceived market participants by knowingly misleading them into thinking that Kraft intended to take delivery of futures contracts when in fact it did not have such an intention.¹⁰

While the court and the CFTC in Kraft may be channeling the FERC's expansive definition of fraud, it is hard to see how this formulation of sending false signals to the market by purchasing futures contracts can be reconciled with established notions of fraud. More significantly, it is unclear how the DOE can prove even this form of "deception," i.e. otherwise legitimate trading activity that is undertaken with wrongful intent, without showing that the defendant actually possessed a subjective intent to manipulate. In other words, proving fraud by demonstrating wrongful intent is simply inconsistent with a rule that purports to do away with the requirement of intent. Similarly, if the argument being put forth by the commission is that all conduct that moves market prices or creates an artificial price "deceives" market participants who have a right to assume that the market price reflects only the legitimate forces of supply and demand, then surely a necessary element of such a claim has to be the existence and creation of an artificial price – an element that the CFTC claims is not required under Rule 180.1.

So, the question remains, if the CFTC is committed to applying Rule 180.1 to all forms of purported manipulation, what standard will it apply. Absent the essential elements of subjective intent to manipulate and causing the existence of an artificial price, what is a manipulation and can it exist without fraud? "Interfering with a well-functioning market" sounds suspiciously like Justice Potter Stewart's standard for pornography: "I know it when I see it."

Commission staff at the DOE have been heard to say that they will not bring cases that are not deserving of enforcement and that they can be "trusted to do the right thing," even if the legal standard is somewhat "elastic." What I think that assurance really means is that DOE is only likely to bring manipulation cases when, in its view, at least one of the traditional elements of manipulation, i.e. intent or artificial prices, are present, even if they do not necessarily assume the burden to prove these elements. But prosecutorial discretion is not an answer to the absence of a coherent, defensible legal standard. The industry deserves better.

Dan Waldman is a senior counsel at Arnold & Porter Kaye Scholer. He is a former general counsel of the Commodity Futures Trading Commission. He is also an adjunct professor at George Washington University Law School, where he teaches courses on derivatives regulation and commodities and energy law.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.