On August 8, 2017, a three-judge panel of the US Court of Appeals for the Seventh Circuit unanimously upheld the first-ever criminal conviction of a New Jersey futures trader for the manipulative trading practice known as “spoofing.” The court affirmed his November 2015 jury conviction, for which he was sentenced to three years in prison.
“Spoofing” is a market manipulation tactic criminalized under the Dodd-Frank Act that involves placing bids to buy or sell securities with the intent to cancel them before execution. This tactic creates an illusion of supply and demand that artificially manipulates the market for the underlying securities. The spoofer then places legitimate trades to capitalize on the artificial price arbitrage. This scheme is typically leveraged in high-frequency trading, which often deals in high volumes of transactions sufficient to manipulate securities pricing within fractions of a second.
Here, defendant Michael Coscia commissioned and employed high-frequency trading methodologies and computer algorithms to rapidly place large and small trade orders on opposite sides of various commodities markets, including gold, soybean oil and high-grade copper. The large orders allegedly created an illusory supply or demand that artificially moved the market in the underlying commodities, which his legitimate small orders capitalized on. Coscia allegedly cancelled the large orders before they could be fulfilled, typically within fractions of a second after placing them. At trial, prosecutors said that his scheme allowed him to make $1.4 million in less than three months in 2011. In addition, they asserted that his manipulation caused economic loss to other traders and market participants.
On appeal, Coscia argued that the Dodd Frank Act’s anti-spoofing provision was unconstitutionally vague and that the evidence prosecutors presented at trial was insufficient to prove his intent to cancel his trade orders before execution. Coscia also asserted that the provision could give rise to arbitrary enforcement, especially for the activity of high-frequency traders, which often involves a large number of cancelled orders.
But the Seventh Circuit panel rejected Coscia’s arguments, holding that the anti-spoofing provision is not unconstitutionally vague because it “provides clear notice and does not allow for arbitrary enforcement” because it requires “the intent to cancel the bid or offer before execution.” In so finding the requisite intent, the court appeared persuaded by the testimony of the computer algorithm designer. At trial, the designer testified about how Coscia wanted his trading algorithms designed to “act like a decoy” and automatically cancel large orders while consummating the small orders. The court also relied on evidence contrasting Coscia’s trading patterns with those of legitimate high-frequency traders.
The Seventh Circuit’s decision is likely to have a significant impact beyond the case at issue. First, the ruling that the anti-spoofing provision is not unconstitutionally vague and does not authorize arbitrary enforcement will certainly be considered both by other Circuits facing similar challenges to the provision and by the government in its future enforcement efforts.
Second, while the decision puts high-frequency traders on alert regarding potential liability for cancelled orders, the court did provide the financial industry with some comfort: legitimate trade orders cancelled following a condition subsequent (e.g., stop-loss orders) differ from spoofing orders that are never intended to be filled. In addition to some recent spoofing settlements individuals have made with the Department of Justice,1 the Securities and Exchange Commission (SEC) has brought a series of enforcement cases involving spoofing,2 and the Staff has publicly stated its continued focus on these manipulative schemes.3
Further criminal and civil enforcement efforts against spoofing are anticipated after this favorable decision for the government. Key factors in future cases are likely to include whether the size of the at-issue trades is consistent with the advance intent to cancel trades to manipulate the market.