"The CFTC’s Fraud-Based Manipulation Authority Raises Questions"

by Skadden, Arps, Slate, Meagher & Flom LLP
Contact

In October 2013, the Commodity Futures Trading Commission used enforcement powers it gained under the Dodd-Frank Act in an order finding that a major financial institution recklessly employed manipulative devices in trading credit default swaps.1 In doing so, the CFTC wielded its fraud-based manipulation rule in a manner that has raised additional questions about CFTC powers that market observers already found troubling — and potentially unconstitutional — since the CFTC implemented its authority two years earlier.

The CFTC and Dodd-Frank

Over the years, the CFTC has used its powers to fight price manipulation, false reporting and fraud in the commodity markets aggressively and capably. In 2010, Congress added to the agency’s already robust arsenal through Dodd-Frank when it enacted a fraud-based manipulation standard for the CFTC that largely mimicked the SEC’s authority under Section 10(b) of the Securities Exchange Act.

Under this standard, the CFTC was authorized to adopt regulations prohibiting “manipulative or deceptive devices or contrivances.” Market observers and participants wondered what conduct would be prohibited that was not already unlawful prior to the enforcement of Dodd-Frank. Observers also questioned how the CFTC would provide adequate notice to market participants of these forms of misconduct that carried significant civil and possibly criminal penalties, or if these powers would allow the CFTC to label as manipulation trading behavior it decided years after the fact was inappropriate or irresponsible.

Rule Adoption and Reaction. In 2011, the CFTC adopted its fraud-based manipulation prohibition, CFTC Rule 180.1, modeled after SEC Rule 10b-5.2 The CFTC seemed to recognize that market participants needed notice of what new kind of misconduct was prohibited but was no more helpful than stating “Rule 180.1 augments the Commission’s existing authority to prohibit fraud and manipulation.”3 The CFTC did clarify, however, that unlike its existing authority to prohibit manipulation, it only would have to prove that the forms of misconduct were committed recklessly rather than intentionally, a point which offered little comfort to market participants.

Commenters on the proposed rules warned the CFTC that, without further clarification, Rule 180.1 could be unconstitutionally vague because it failed to provide sufficient notice regarding whether a practice ran afoul of the rule and exposed market “participants to the threat of arbitrary and unfair enforcement.”4 The CFTC, however, adopted the rule as proposed.

The 2013 CFTC Order

In 2013, the CFTC found certain credit default swap (CDS) trading in violation of Rule 180.1. The CFTC alleged that a bank’s CDS traders established positions during a price settlement period with the intent to create an artificial settlement price. The traders allegedly did this because the settlement price was used for marking-to-market the bank’s CDS position, and an artificial price would mask significant losses the bank suffered on its CDS positions. If true, these facts could reasonably fit the CFTC’s often relied-upon “banging the close” theory (entering trades at the end of a trading period in a manner designed to exert artificial pressure on the settlement prices) in violation of the CFTC’s pre-Dodd-Frank market manipulation prohibitions.

However, the CFTC did not allege such a violation; instead, the order found that the traders employed a manipulative device “because they sold enormous volumes of [CDS] in a very short period of time at month-end.” Their actions were reckless because they were “operating out of desperation to avoid further losses,” the size of the position had the potential to affect the market, and the traders sold during a concentrated time period of the market. Thus, the traders “interfered with free and open markets” and traded with a “reckless disregard to obvious dangers to legitimate market forces …. “

The CFTC’s order raises a host of unanswered questions regarding a Rule 180.1 violation:

  • At what point did the volume of trading become “enormous” such that it embodied reckless behavior?
  • How short is a “very short period of time”?
  • What constitutes “interference”?
  • What are “legitimate market forces” or “free and open markets”?5

The most troublesome questions, however, are raised by the CFTC statement in the order that a trader can be held liable even if motivated by a “desire to obtain compensation rather than by a desire to affect a market price.” Is the CFTC suggesting that trading to avoid losses or trading to obtain compensation in the absence of any intent to affect the market price is not a legitimate market force? Does such trading truly interfere with free and open markets? Can trading to minimize losses and maximize profits by itself be illegitimate or deemed to interfere with free and open markets?

Implications

As market participants consider how the CFTC’s order may affect their 2014 trading activity, the CFTC’s statement adds another layer of complexity and uncertainty. Ironically, under the CFTC’s rationale, trading large amounts of derivatives in a market exclusively with a motive to profit from that trading can be a manipulative or deceptive device and can violate Rule 180.1, even though the same trading activity, but in smaller volumes or in the same volume stretched out over a longer period of time, apparently would not be a violation. Market participants may find themselves asking how the CFTC will distinguish acceptable trading volumes from “enormous” quantities, as regulatory direction remains far from clear.

__________________

1 In re J.P. Morgan Chase, Docket No. 14-01 (CFTC Oct. 16, 2013).

2 Section 6(c) of the Commodity Exchange Act makes it unlawful to employ any manipulative or deceptive device or contrivance in connection with a swap, future or contract of sale of any commodity in contravention of CFTC rules. CFTC Rule 180.1 implements Section 6(c) and makes it unlawful to intentionally or recklessly employ any manipulative device, scheme or artifice to defraud in connection with a swap, future or contract of sale of any commodity.

3 Prohibition on the Employment, or Attempted Employment, of Manipulative and Deceptive Devices and Prohibition on Price Manipulation, 76 Fed. Reg. 41398, 41401 (July 14, 2011).

4 76 Fed. Reg. at 41400.

5 Another unanswered question is how the CFTC views the temporal reach of its jurisdiction over swaps. The conduct at issue in the order occurred in January and February 2012, and the order cites CFTC Rule 1.3(zzz) as its jurisdictional basis. Rule 1.3(zzz) defines which security-based swaps are subject to CFTC as opposed to SEC oversight; however, Rule 1.3(zzz) was not adopted until August 2012 and was not effective until October 2012 — more than seven months after the alleged conduct.

* This article appeared in the firm's sixth annual edition of Insights on January 16, 2014.

Download PDF

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Skadden, Arps, Slate, Meagher & Flom LLP | Attorney Advertising

Written by:

Skadden, Arps, Slate, Meagher & Flom LLP
Contact
more
less

Skadden, Arps, Slate, Meagher & Flom LLP on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
Privacy Policy (Updated: October 8, 2015):
hide

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.

Security

JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.