The Commodity Futures Trading Commission (CFTC), on April 22, 2010, adopted a civil penalty settlement concerning claims that San Diego Gas & Electric Company (SDG&E) violated the prohibition on wash sales in Section 4c(a) of the Commodity Exchange Act, 7 U.S.C. § 6c(a) (2006), in connection with the sale and purchase of natural gas futures contracts.1 There have not been any wash sale enforcement settlements, or related orders, concerning energy products since the period following the collapse of Enron. As a result, it provides important guidance for energy companies as to the applicable legal standards for wash sales.
As set forth in the order, during the period January 26, 2006, through February 2, 2006, an SDG&E employee placed market orders with an introducing broker for the execution of natural gas futures contracts on the New York Mercantile Exchange (NYMEX) that had the effect of liquidating and then re-establishing the same NYMEX Contracts with a minimal price difference. The order to sell and the order to buy the futures contracts were placed on the same phone call, and the SDG&E employee requested that the prices for each be at or near the same price. Upon those instructions, the introducing broker placed simultaneous purchase and sale orders with NYMEX floor brokers that resulted in the floor brokers executing the sell order and the purchase order about the same time at about the same price. SDG&E maintained that it executed the transactions solely to manage its internal liquidity and risk management limits. The CFTC order acknowledges that while SDG&E’s purpose in executing the futures orders was to liquidate and re-establish its positions, there was no allegation or finding that any SDG&E employee engaged in fraudulent misconduct with respect to the transactions.
Section 4c(a) of the Commodity Exchange Act prohibits wash sales. As explained in the order, a wash sale “is a transaction made without an intent to take a genuine, bona fide position in the market, such as a simultaneous purchase and sale designed to negate each other so that there is no change in financial position.”2 Wash sales are considered to be serious violations even in the absence of customer harm or noticeable market effect because, as the order explains, they undermine confidence in the market mechanism that underlies price discovery. Wash sales may mislead market participants because they do not reflect the forces of supply and demand and may give a false impression with respect to market liquidity.
As this settlement order makes clear, it is not necessary for the CFTC to show an intent to mislead. The focus is on the customer’s intent, at the time of the transactions, to negate or reduce market risk to a level that has no practical impact on the transactions. The essential characteristic of a wash sale is the intent to avoid making a bona fide transaction or taking a bona fide position in the market. As highlighted in the order, the “factors that show a wash result are (1) the purchase and sale (2) of the same delivery month of the same futures contract (3) at the same (or a similar) price.”3 As a result, the reasons why SDG&E executed the offsetting transactions were not relevant. What was important was that offsetting transactions were executed with the intent to avoid any market risk or change of position. SDG&E agreed to pay a civil penalty of $80,000 to settle the claims.