On Feb. 1, the CME Group submitted to the Commodity Futures Trading Commission (CFTC) rule changes for all of its exchanges – CME, CBOT, NYMEX and COMEX as well as the CME Swaps Execution Facility – that may significantly expand the self regulatory organizations’ (SRO) enforcement activity involving manipulation and fraud claims. These rule changes are being made at the behest of the CFTC, suggesting that the CFTC may be looking to the exchanges to fill the gap left by the resource constraints and legal hurdles the CFTC faces in pursuing manipulation and fraud cases itself.
The rule changes, effective on Feb. 16, 2017, essentially add “attempted” violations of existing exchange rules prohibiting manipulation, false reporting and fraud. They also expand the scienter standard to include not only “intentional” violations, but also “reckless” violations. Moreover, in adding these expansive elements to the anti-manipulation rule, the exchanges adopted language directly from the CFTC’s Rule 180.1, which was adopted in 2011, making it a violation “to intentionally or recklessly use or employ, or attempt to use or employ, any manipulative device, scheme, or artifice to defraud.” Indeed, the announcement of these rule changes states expressly that they “are intended to more closely track the prohibitions set forth in CFTC Regulation 180.1 which concern abusive trade practices ....”
The predecessor of these changes is the provision added to the Commodity Exchange Act (CEA) by the Dodd-Frank Wall Street Reform and Consumer Protection Act3 (Dodd-Frank) to make it easier for the CFTC to bring and win manipulation cases. That provision was modeled on section 10(b) of the Securities Exchange Act of 1934, with one notable exception: The provision added to the CEA expressly states that attempts will constitute violations. Dodd-Frank also added a provision stating that providing false information that affects or tends to affect the price of any commodity in interstate commerce violates the law, when “knowing, or acting with reckless disregard of the fact that such report is false, misleading or inaccurate.” Moreover, the CFTC subsequently promulgated Rule 180.1, which tracked SEC Rule 10b-5, also with one notable exception — the CFTC rule expressly makes reckless conduct a violation. In addition, while Congress had manipulation in mind when it enacted this provision of Dodd-Frank, by using the language of section 10(b), the provision in fact has allowed the CFTC to use it not just in manipulation cases but in fraud cases as well.
The CME Group has now grafted these concepts of recklessness and attempted manipulation, false reporting and fraud into its own rules. Although we will have to wait to see how the exchanges’ enforcement departments use these provisions, they open the door to a much wider assertion of authority over these areas under the SRO disciplinary process, and thus create the prospect that behavior that is subject to varying interpretation may more easily give rise to exchange scrutiny and serious consequences for the market participant.
This may be particularly true for cases of alleged manipulation. Cases involving allegations of actual manipulation of commodity or futures prices have been notoriously hard for the CFTC to prosecute, in part because they require an economic analysis proving that an artificial price was in fact created by the defendant’s actions and because they usually involve years of pretrial discovery. While the CFTC in theory can bring administrative cases before the agency’s own administrative law judges,8 for budgetary and other reasons there have not been any administrative law judges at the CFTC for many years. As a result, virtually all of its cases are brought in federal court where defendants have a number of procedural tools at their disposal, including pretrial discovery and a right to a trial by jury. Under whichever standard — the longstanding manipulation provision of the CEA or the newly added statutory language — manipulation cases are almost always complex, with facts and experts pointing in different directions. Given the federal courts’ rules of discovery and evidence, and their independent fact-finders and law-deciders, the CFTC must be willing to commit significant resources to fighting a case and it has a questionable likelihood of success in many cases. The CFTC’s resources are extremely strained and are likely to remain so for the foreseeable future, and therefore, the CFTC must choose its battles carefully.
Expanding the role of the SROs in these cases not only is a potential remedy to the CFTC’s resource limitations, but it increases the odds of a defendant being held liable. The SRO process involves a hearing before an exchange business conduct committee that renders a decision, internal review, then a possible appeal to the CFTC, all before having any right to appeal to a federal appeals court. Once in the courts, the review available is much more constrained both as a legal and a practical matter than it is when litigation is initiated and tried in federal district court. Thus, fighting a claim under SRO rules is less practical and less likely to produce a successful outcome for a defendant, even one with a viable defense. At the same time, the consequences of being sanctioned by the exchanges can be as practically devastating as a sanction won by the CFTC, and can include monetary penalties and being barred from further participation in the market.
Viewed through this prism, the expansion of potential liability under SRO rules represented by these changes appears quite significant. Adding a lower standard of scienter and permitting cases based on attempted misconduct alone, without being required to prove that an artificial price resulted from the defendant’s conduct, will lead to a broader category of behavior being subject to sanction.
There are additional risks as well. While proving a completed manipulation requires proof that some prices have actually been manipulated — which is not an easy task — a claim of attempted manipulation under the CEA has historically required only proof of an intent to manipulate and some act in furtherance of that attempt. Until Dodd-Frank, it was always understood that, “It is the intent of the parties which separates otherwise lawful business conduct from unlawful manipulative activity.” When a lower “recklessness” standard is layered on top of the lower standards needed to prove an attempted manipulation, that is, proof of a specific intent to manipulate is no longer required, it becomes very hard to discern exactly where a trader will cross the line into improper conduct; what exactly does it mean to act with reckless disregard for the possibility that your conduct will introduce into the market a factor that is not “a legitimate force of supply or demand?” As the CFTC itself wrote in 1982, “[w]e are unable to discern any justification for a weakening of the manipulative intent standard which does not wreak havoc with the market place.”
The fact that these vague and undefined standards of misconduct are now part of the SRO rulebook should cause all market participants more than a moment of concern, particularly in light of the difficulties in prevailing in an SRO proceeding and the real possibility that the CFTC will look to the exchanges to increase enforcement. It will be important to watch carefully how the exchanges begin to use these expanded rules and what it may mean to traders trying to participate actively in the markets without fear of stumbling into serious sanctions.