In March 2013, The Wall Street Journal reported that the Commodity Futures Trading Commission (CFTC) is examining the setting of prices in the gold and silver rings on the London Metal Exchange. In February 2013, the CFTC settled an enforcement proceeding against the Royal Bank of Scotland with respect to its London-based conduct in connection with the setting of Libor and Eurobor. That settlement followed on the heels of settlements with Barclays Bank and UBS in connection with their submissions for Libor and Yen Libor in London and Tokyo. These enforcement actions are the most dramatic illustrations of the CFTC’s Pax Americana view of its power to police the global financial markets. These developments should be of great concern to hedge funds and private equity funds operating internationally.
CFTC Expands Its Extraterritorial Jurisdiction
From time to time in the past, the CFTC has exercised its jurisdictional reach to address conduct in markets outside of the United States, but typically when there was a nexus to actual conduct in the US as well. Since the collapse of the financial markets in 2008 and the adoption of Dodd-Frank, however, the CFTC has embraced an aggressive and expansive view of its extraterritorial jurisdiction to police the financial markets. Many hedge funds and private equity funds regularly conduct their investment activities in a way that could cause them to fall within the CFTC’s jurisdiction.
Under the Commodity Exchange Act, the CFTC has jurisdiction over the trading of a commodity or futures contract that affects the price or the trading of the commodity or the related futures contract in “interstate commerce.” Title VII of Dodd-Frank has strengthened the CFTC’s view of its jurisdiction. As a result, the CFTC has concluded that it has jurisdiction to police any conduct regarding the pricing or trading of commodities and commodity futures contracts outside of the US that may have an impact through economic forces on prices in the US.
The Libor cases reveal the expansive reach of the CFTC’s extraterritorial jurisdiction. Each of those enforcement actions resulted in fines in the hundreds of millions of dollars for the CFTC. Even though those enforcement actions were pursued in concert with regulatory authorities in the United Kingdom, the CFTC drove the investigation and the settlements. In two of the three instances, none of the conduct occurred whatsoever in the US. In the third instance, almost all of the conduct occurred outside of London―only a portion of the pre-2008 conduct occurred in the US. In all three enforcement actions, the CFTC premised its jurisdiction on its findings that Libor is the basis of the settlement of interest rate futures and options contracts on all of the world’s major futures and options exchanges, including the Chicago Mercantile Exchange, and that Libor has a widespread impact on the consumers and businesses for which Libor is a benchmark interest rate.
The CFTC has taken a similarly aggressive view with respect to the regulatory authority conferred by Dodd-Frank with respect to swaps transactions. In its July 12 Proposed Interpretative Guidance entitled Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act (77 Fed. Reg. 41214 (Jul. 12, 2012)), the CFTC adopted a sweeping view of its ability to regulate swaps transactions outside of the US because it “believes that US persons’ swap activities outside of the United States have a direct and significant connection with activities in, or effect on, US commerce.”1
Consequently, the CFTC has proposed that its regulations apply to a non-US person if a swap solicited by a US branch agency, affiliate or subsidiary of the non-US person is booked by the non-US person, or if a non-US person exceeds the de minimus threshold for swap dollars or the requirements for Major Swap Participants. In addition, when one of the counterparties is a US person, “the Commission proposes to interpret Section 2(i) [of the Commodity Exchange Act] in a manner so that the Dodd-Frank Act requirements relating to clearing, trade-execution, real time public reporting, Large Trader Reporting, and SDR Reporting and recordkeeping apply to such swaps.”2 The CFTC proposes adopting this interpretation, even though it acknowledges that its extraterritorial application of its regulations may result in two or more jurisdictions asserting authority over the same swap transactions.
Market Participants Should Stay Alert
As these recent events demonstrate, any participant in the global markets for commodities or futures contracts, including hedge funds and private equity funds, has to be alert to the CFTC’s enforcement power and the obligations imposed by the CFTC’s regulations. Separate and apart from compliance with regulatory requirements for swap transactions and registration, market participants need to be most alert to the CFTC’s willingness to take enforcement action against conduct that it believes has manipulated prices. As a result of amendments that Dodd-Frank made to the anti-manipulation provisions of the Commodity Exchange Act, the CFTC has expanded its definition of what constitutes unlawful conduct. Under Rule 180.1, which was adopted as a result of Dodd-Frank, the CFTC is empowered to pursue enforcement actions against a party who uses a manipulative device, scheme or artifice to defraud; makes an untrue or misleading statement of fact; or engages in a course of conduct that would operate as a fraud in connection with a swap, a contract to sell a commodity or a contract for future delivery. Importantly, under this rule, there is no specific intent requirement, and the CFTC has to establish only that the conduct was reckless (i.e., the conduct involved “an act or omission that ‘departs so far from the standards of ordinary care that it is difficult to believe that the actor was not aware of what he or she was doing’”).
Non-US hedge funds and private equity funds that trade outside of the US, like domestic-based funds or funds that trade in the US markets, are exposed to the risk of CFTC enforcement actions. If a fund engages in questionable trading in London or some other foreign market that may have an impact on prices in the US (which is almost invariably the case), the fund is at risk of an enforcement action. If the CFTC believes that trading conduct may have distorted prices, there is a meaningful risk that the CFTC will seek to investigate and to take action against such conduct. As illustrated by enforcement actions that the CFTC has commenced in the past, such conduct can include efforts to squeeze a market by acquiring and holding large physical positions on an exchange when there may not be a commercial need for the physical commodity,3 efforts to “bang the close” by trading substantial volumes of contracts at the close in order to move the settlement price,4 or other efforts to affect the price of a commodity or a futures contract.5 Similarly, a fund may be at risk if it can be seen as engaging in wash trading or prearranged trading.6
Funds Should Adopt Compliance Programs
These risks mandate that funds and other market participants, be they located in or outside the US, strengthen their compliance activities. If a fund’s trading activity is large enough to have a market impact, it is important that it establish systems to monitor such trading activity on a routine basis. Many significant CFTC enforcement actions over the past decade, be they concerning Libor or other market activities, have resulted because of the absence or breakdown of compliance systems to monitor trading activity. Indeed, as part of the Libor settlements, the banking institutions had to agree to establish substantial compliance and monitoring programs to prevent a repetition of such conduct.
The adoption of prophylactic compliance programs is important for many reasons. Not only will such programs protect a fund against an enforcement action by the CFTC, but they will also protect the fund from the substantial class action litigation that almost always follows in the wake of enforcement actions. Large institutions generally have an ability to absorb such litigation risks. The risk of civil litigation can be devastating, however, for hedge funds and private equity funds, as illustrated by the collapse of Amaranth as a result of its manipulative trading in the mid-2000s.