Almost two years ago, Judge Richard Sullivan, then a district court judge in the SDNY, presided over a trial in which the CFTC charged prominent trader Don Wilson and his company, DRW, with violating sections of the Commodity Exchange Act (“CEA”) that prohibit commodities manipulation and attempted manipulation. Last month, Judge Sullivan, now a newly-minted judge on the Second Circuit, issued his opinion in the much-watched case, CFTC v. Donald R. Wilson, 13 Civ. 7884 (RJS) (Dec. 3, 2018). Sullivan’s decision finding that the CFTC failed to prove that Wilson’s admitted (and successful) efforts to move the price of an IDEX interest rate swap violated the CEA’s prohibition against manipulation was a serious setback to the CFTC’s efforts to use the seldom-litigated ban against manipulation codified in Section 9(a)(2) of the CEA.
The CFTC’s Division of Enforcement has long been responsible for policing manipulation in the derivatives and commodities markets. For many decades, its primary and, until Dodd-Frank, only, tool in battling manipulation has been the prohibition against manipulation found in Section 9(a)(2) of the CEA.
The prohibition against manipulation found in Section 9(a)(2) of the CEA is notoriously difficult to enforce, requiring the Commission to establish that “(1) Defendants possessed an ability to influence market prices; (2) an artificial price existed; (3) Defendants caused the artificial prices; and (4) Defendants specifically intended to cause the artificial price.” In re Amaranth Nat. Gas Commodities Litig., 730 F.3d 170, 183 (2d Cir. 2013).
This standard is so difficult to meet that the CFTC rarely chooses to litigate it, and when it does, it has a spotty record of success. In fact, CFTC’s record in enforcing the 4-part standard under § 9(a)(2) was so poor that it was cited as one of the rationales for the inclusion in the Dodd-Frank Act of a new type of anti-manipulation authority in the CEA. Codified in Section 6(c)(1) of the Act and Rule 180.1 subsequently promulgated by the Commission, this new anti-manipulation authority explicitly cribbed language from Section 10b of the Securities Act and SEC Rule 10b5. Section 180.1 thus prohibits any “manipulative device, scheme or artifice to defraud.” 17 C.F.R. § 180.1.
Less complicated than Section 9(a)(2)’s 4-prong test, 180.1 manipulation also has a lower scienter threshold than old-school manipulation, as the new authority can be satisfied by showing that the defendants acted recklessly, rather than intentionally. Since being granted this new authority, the CFTC has made good use of it, bringing a number of cases under Rule 180.1, including a host of “file and settles,” but also a number of litigated matters.
In 2015, the CFTC charged Kraft Food Group with violating both Regulation 180.1 and Section 9(a)(2) by manipulating the price of wheat futures. The court in that case subsequently rejected a motion to dismiss charges under both sections, noting that the “new authority was intended to ‘augment the Commission’s existing authority to prohibit fraud and manipulation’ under Section 9(a)(2).” CFTC v. Kraft, 25 CV 2881 (N.D. Ill. 2015), at. 13. However, the Kraft court went on to hold that, despite the disjunctive language in both the statute and regulation (manipulation or fraud), 180.1 “prohibits only fraudulent manipulations, that is, those involving deception, misrepresentation, or other form of fraud.” Id. at 19.
Judge Sullivan’s Opinion
The DRW case represented the first anti-manipulation case to go to trial in recent memory. It charged Wilson and his company with violating § 9(a)(2) by submitting bids during a 15-minute settlement window with the intention of increasing the value of positions held by DRW in a related contract. Because Wilson’s conduct had terminated before the effective date of the relevant Dodd-Frank provisions, the Commission did not have available to it the new anti-manipulation provisions of Rule 180.1.
Many of the facts in the case were not disputed. Before the financial crisis of 2008, virtually all swaps were traded “over the counter” (“OTC”), where the parties would negotiate a bilateral transaction without the intervention of a central counterparty like an exchange. That changed with Dodd-Frank, which mandated the movement of certain types of swaps onto exchanges in order to reduce counterparty risk. With respect to interest-rate swaps, this change arguably created a “convexity bias” whereby long positions in swaps traded on exchange were worth considerably more than the equivalent OTC swap. DRW believed it had identified and could take advantage of this anomaly in the market by taking a long position in relatively undervalued interest rate swaps. Wilson, however, grew frustrated when the market did not behave as he predicted and took it upon himself to move the market higher by submitting bids during the settlement window for the IDEX USD Three-Month Interest Rate Swap Futures Contract, an exchange-traded interest rate swap futures contract used to calculate variation margin on a long position held by DRW with a notional value of $300 million.
To effectuate that strategy, Wilson acquired software that allowed him to submit electronic bids directly to the exchange and began placing electronic bids during the settlement window of 2:45 to 3:00 p.m., with the intention of using these bids to move the settlement price higher. During the first six months of 2011, DRW submitted more than 2,500 electronic bids. None of these bids led to a consummated sale, but they were successful in moving the settlement price higher and increasing the value of Wilson’s pre-existing long position by millions of dollars.
Judge Sullivan noted that “[t]here is no disagreement about” why Wilson structured his bids in this manner: “Defendants knew that their trading practices and, more specifically, their bids, would result in a higher settlement price…Indeed, in such an illiquid market the effects of these bidding practices were predictable.” CFTC v. DRW, at 9. Moreover, “DRW freely admitted to concentrating its bids during the settlement window, which was the only way in which its traders could contribute to price discovery.” Id. at 10.
“Contributing to price discovery,” is a relatively euphemistic way of describing DRW’s determination to push the settlement price higher, which as the CFTC repeatedly noted during trial, was accomplished through the established tactic of “banging the close.” Nevertheless, Judge Sullivan found that, while the first prong of the § 9(a)(2) standard (ability to influence prices) was indisputably met, the CFTC had failed to meet its burden under the other three prongs because it had failed to show that the higher price that DRW was admittedly trying to achieve was an “artificial price.”
This goes back to the convexity bias, or “convexity effect.” Because IDEX was using OTC prices to set the price of an on-exchange interest rate swap, DRW believed, and in litigation argued, that the pre-existing price was wrong, and that, while DRW’s bids were intended to move the price, they were intended to move the price to the correct number. In other words, DRW’s actions were not manipulative because they were trying to fix a flaw in an illiquid market by moving the price to the “natural,” rather than “artificial,” price.
Judge Sullivan derided the CFTC’s attempt to show that the higher price desired and achieved by DRW was “artificial,” characterizing as “circular” and “tautological” the argument that because the price was effectively set by DRW and not the product of the natural forces of supply and demand the price was inherently “artificial.” Id., at 17-18. He further placed great weight on DRW’s willingness to transact at the price of its bids, which he regarded as proof that Wilson genuinely believed that the pre-existing price of the contract was “artificially” low. See, e.g., id. at 27. Finally, Judge Sullivan’s opinion suggests that, not only did Wilson believe that the “true” or “natural” price should be higher, Sullivan himself believes that Wilson was right. Thus the opinion concludes with the trenchant but uncontroversial comment that “[i]t is not illegal to be smarter than your counterparties in a swap transaction, nor is it improper to understand a financial product better than the people who invented that product.” Id., at 26.
Judge Sullivan’s opinion in DRW could have a profound impact on the efficacy of the CFTC’s anti-manipulation enforcement program. First, as mentioned above, the number of litigated § 9(a)(2) cases is vanishingly small, and that fact alone means that, absent reversal, Judge Sullivan’s opinion is destined to be widely cited in pending and future cases.
Second, the CFTC’s challenge of prevailing in future 9(a)(2) cases will be more difficult given the DRW court’s acceptance of Wilson’s argument that intentionally moving the price of a product to a different price that the mover believes (or purports to believe) is the correct or “natural” price can’t be manipulation. Most traders can articulate a reason that the price they prefer is also the “right,” “true,” or “natural” price, and most defendants can find an expert economist to opine that they are correct. Sullivan’s opinion appears to require the government to prove that any such rationale is pretextual, and even proving attempt to manipulate under § 9(a)(2) would require the government to show that the defendant knew that his desired price was artificial or unnatural.
And it is not clear how the CFTC could show artificiality to Judge Sullivan’s satisfaction. The court found “tautological” and “circular” the CFTC’s argument that Wilson’s desired price was “artificial” because the price was determined by the desires of Wilson himself rather than the natural forces of supply and demand. But this tautology is built into the law, which unhelpfully defines an artificial price under the CEA to be one that “does not reflect the market or economic forces of supply and demand.” In re Indiana Farm Bureau Coop. Ass’n, [1982-1984 TRANSFER BINDER] CFTC No. 75-14, Comm. Fut. L. Rep. (CCH) ¶ 21,796, 1982 WL 30249, at *4 n.2 (1982) (“Indiana Farm Bureau”)
There is little guidance in the case law as to how the Commission is to distinguish between the legitimate forces of supply and demand and extrinsic, artificial forces, particularly with respect to illiquid markets. Although another court in the SDNY previously held that “a price may be artificial if it is higher than it would have been absent Defendants’ conduct,” CFTC v. Parnon Energy Inc., 875 F. Supp. 2d 233, 247 (S.D.N.Y. 2012), it is hard to square that language with Judge Sullivan’s decision in DRW.
Therefore, there is a risk that § 9(a)(2), an already rarely-litigated section of the CEA, could fall into desuetude. Perhaps this matters less post-Dodd-Frank, which with Rule 180.1 established an entirely new anti-manipulation authority that the CFTC has already begun charging regularly. However, Rule 180.1 was clearly designed to augment, not replace, traditional § 9(a)(2) anti-manipulation authority, and since the Kraft court’s 2015 decision finding Rule 180.1 to be limited to “fraud-based manipulation,” the CFTC has not resisted the conclusion that 180.1 manipulation must sound in fraud. In many cases, the requirement that the Commission prove some sort of fraud, deception or dishonesty in connection with moving the price may not be difficult to surmount; the Kraft court itself found this element satisfied by Kraft’s alleged creation of “false demand” for futures on wheat for which it never intended to accept delivery. According to the court in that case, “Kraft, through its activities in the market, conveyed a false sense of demand, and the resulting prices in the market (both of cash wheat and of wheat futures) were based not solely on the actual supply and demand in the market, but rather were influenced by Kraft’s false signals of demand.” Kraft, at 27.
However, even if courts in future cases brought under Rule 180.1 were to define evidence of fraud as liberally as the Kraft court, it is clear that certain cases of alleged manipulation will not be prosecutable as “fraud-based manipulation.” The DRW matter is a case in point. As Judge Sullivan repeatedly found, DRW made no secret of its conviction that the pre-existing price for the swaps in question was lower than it should be; this candor would likely have been fatal to any case brought under rule 180.1, had the conduct in questions continued after the effective date of Dodd-Frank.
Some of this regulatory slack could be taken up by continued vigorous use of the anti-spoofing provision of Dodd-Frank, a new enforcement authority that has quickly become a favoed weapon in the CFTC’s arsenal. To prevail in a spoofing case, the CFTC need only show that, at the time that a bid or offer was submitted, the defendant intended to cancel before consummation. Although spoofing is often used as a tactic by which to manipulate the price of a commodity or derivative, to prevail in a spoofing case the Division of Enforcement does not need to prove that manipulation was the ultimate goal of a spoofer.
If a market participant can credibly show that it subjectively believed that the price to which it was trying to move a particular market was the “natural,” rather than artificial, price, the underlying fact that it was trying to move the price wouldn’t be adequate, under the logic of Judge Sullivan’s opinion, to prove up manipulation in violation of § 9(a)(2). This will make it that much harder for the CFTC to enforce an already challenging prohibition against manipulation.
 See, e.g., Sept. 17, 2009, Press Release from Senator Maria Cantwell (“Current law makes it difficult for the Commodities Futures Trading Commission to effectively meet its mandate to investigate and punish market manipulation, resulting in little or no deterrent against abusive practices. This is because current law sets a very high bar for the CFTC to prove market manipulation.”).
 More recently, a district court in California reached a mirror-image conclusion in a Rule 180.1 fraud case, ruling that the CFTC had to show that the fraud charge had involved manipulation as well. CFTC v. Monex Credit Co., 17- CV-01868 (JVS) (C.D. Ca) (May 1, 2018).
 In a stark departure from the adage that “success has many fathers, and defeat is an orphan,” the DRW litigation stretched through the tenures of three Directors of Enforcement, as it was filed before the author became Director in 2014 and wasn’t decided until almost two years after the author departed the Commission.
 At the time that this post was written, the CFTC had not filed a notice of appeal, but it still had time before the deadline.
Aitan Goelman is a partner and the Chair of the Securities and Commodities Litigation Practice in the Washington office of Zuckerman Spaeder LLP, and former Director of the Division of Enforcement at the U.S. Commodity Futures Trading Commission.
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