A US federal court in New York City ruled that the Commodity Futures Trading Commission did not meet its burden of proof in its enforcement action against DRW Investments, LLC and Don Wilson, its chief executive officer. The CFTC had charged the defendants with manipulation and attempted manipulation of the IDEX USD Three-Month Interest Rate Swap Futures Contract from January 24 through August 12, 2011.
The court held that the defendants’ trading activities were legitimate and were consistent with their view that the futures contract’s design was flawed and that the futures instrument was inherently more valuable than a comparable over-the-counter contract. According to the court, “[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.”
The CFTC initially filed charges against the defendants in 2013.
According to the Commission, DRW established a long position in the Three-Month Contract beginning in August 2010. Afterwards, alleged the CFTC, beginning in December 2010, the defendants placed bids “that DRW knew would never be accepted” to artificially influence the settlement prices in their favor during the 15-minute period that most influenced settlement prices on at least 118 trading days, in a “banging the close”–type scheme.
A four-day bench trial before the Hon. Richard Sullivan ensued in December 2016. Afterwards, attorneys for the Commission argued during their closing argument that it was the intent of defendants to produce a “price distortion” through placement of “illegitimate bids during the closing period day after day for seven straight months” that favored defendants’ existing positions by prompting favorable settlement prices. Among other things, said the Commission, defendants’ bids were illegitimate because they knew there was no market interest on the other side.
The court, in a decision by the Hon. Mr. Sullivan – now a judge on the Circuit Court of Appeals for the Second Circuit – rejected the CFTC’s arguments that the defendants’ conduct constituted manipulation or attempted manipulation.
The court said defendants determined that, at the time, a long position in the Three-Month Contract was more valuable than a corresponding long position in an OTC swap contract because the futures instrument did not appropriately account and adjust for long position holders receiving variation margin payments when interest rates were rising, while short position holders received variation margin payments when interest rates were declining. Long position holders of Three-Month Contracts thus received their variation margin payments at a better time to invest. This s0-called "convexity effect" did not typically exist in corresponding OTC swaps in 2011 as no variation margin passed between counterparties, observed the court. As a result, long positions holders of Three-Month Contracts had a more advantageous holding than holders of a corresponding OTC swap instrument.
In response, said the court, each day, the defendants would place bids during the closing periods below and up to their calculation of fair value. The court acknowledged these bids helped increase the value of defendants’ open positions in the Three-Month Contract by impacting settlement prices. However, the court found that defendants’ trading was consistent with their quantitative analysis, and they were always interested to attract counterparties and obtain executions. According to the court, the defendants “made bids with an honest desire to transact at those prices, and … they fully believed the resulting settlement prices to be reflective of the forces of supply and demand.”
In order to prove manipulation, said the court, the CFTC had to show that defendants had the ability to influence market price, an artificial price existed, defendants caused the non-bona fide price, and defendants intended to cause the non-legitimate price. To show attempted manipulation, explained the court, the Commission did not have to show an artificial price existed, but had to show that defendants intended to cause an artificial price. However, the court ruled that it was not manipulation or attempted manipulation for defendants to take advantage of flawed exchange rules that were public information where their bids reflected their bona fide perception of fair value and were designed to induce liquidity. The IDCH settlement prices were not artificial, ruled the court, and defendants did not intend to cause an illegitimate settlement price through their actions.
The court noted that, during trial, the CFTC “unrelentingly” also described defendants’ conduct as “banging the close.” While acknowledging that courts have not precisely defined this term, the court said that defendants’ trading activities were not captured by its common meaning as agreed by the parties. “[A] slogan is a poor substitute for evidence, particularly where the slogan doesn’t fit the facts of the case,” said the court.
The Three-Month Contract was offered on the NASDAQ OMX Futures Exchange (NFX) during the relevant time and was cleared through the International Derivatives Clearing House. The Three-Month Contract was delisted by NFX on December 16, 2011, for failing to attract liquidity.
In response to the Court's verdict, DRW and Mr. Wilson issued the following statement:
We are gratified by the Court’s decision, which confirms our long-held position that our trading activity was lawful, legitimate and in line with market regulation. Importantly, the Court affirmed that artificiality is required for market manipulation to have occurred. Today’s decision upholds the principles of price discovery, transparency and integrity in the markets.
(Click here for a greater discussion of the closing arguments in the defendants’ trial and additional background on the CFTC enforcement action in the article “Judge Questions CFTC’s Theory of Markets in DRW Alleged Manipulation Case During Closing Arguments” in the December 11, 2016 edition of Bridging the Week.)
Legal Weeds: The court’s decision in the CFTC’s enforcement action against defendants was decisive although its precedent value may be limited because of the unique facts of the case.
Here defendants took advantage of a design flaw in an exchange futures contract and settlement rules to benefit their existing position in the relevant Three-Month Contract. The court held this was not manipulation or attempted manipulation because the CFTC failed to meet its burden of proof that the defendants specifically intended to cause an artificial price, let alone caused an artificial price. Indeed, said the court, defendants’ bids were consistently lower than its objectively supported view of the contract’s true value. According to the court, “DRW’s bidding practices actually contributed to price discovery rather than price manipulation.”
Moreover, if defendants’ bids were above market value as alleged by the Commission, market participants would have “surely” accepted such bids knowing they could profit when prices returned to their natural levels. The court criticized the Commission for making a “tautological’ argument that prices were artificial solely because defendants attempted to “affect prices.” However, said the court, this position, if “taken to its logical conclusion would effectively bar market participants with open positions from ever making additional bids to pursue future transactions.”
In its complaint against defendants, the CFTC solely relied on the traditional provisions in relevant law prohibiting manipulation and attempted manipulation because the challenged conduct occurred prior to the effective date of a new provision of law prohibiting fraud-based manipulation under the Dodd-Frank Wall Street Reform and Consumer Protection Act. (Click here to access 7 U.S.C. § 9(3) (prior to D0dd-Frank, effectively 7 U.S.C. § 9) and here for 7. U.S.C. § 13(a)(2) – the CFTC’s traditional anti-manipulation authorities. Click here to access 7 U.S.C. § 9(1) – the CFTC’s new Dodd-Frank authority.)
Under this new provision, it is now prohibited for any person to engage in “any manipulative or deceptive device or contrivance” in connection with any swap, or a contract of sale of any commodity in interstate commerce or any futures contract in violation of any rule the CFTC might adopt. The CFTC has, in fact, adopted a specific rule related to this statutory provision, and has used the law and rule to prosecute a wide swath of conduct – from its first use by the CFTC in a 2013 enforcement action against JP Morgan in connection with its “London Whale” episode to subsequent enforcement actions involving illegal off-exchange metals transactions; claims of more traditional manipulation of wheat; allegations of spoofing; and charges of insider trading. (Click here to access CFTC Rule 180.1; click here for background on the CFTC's use of its Dodd-Frank authority in the article, "Ex-Airline Employee Sued by CFTC for Insider Trading of Futures Based on Misappropriated Information" in the October 2, 2016 edition of Bridging the Week.) The CFTC claims it now has broad authority to prosecute persons for their intentional or reckless employment or use of any manipulative device, scheme or artifice to defraud. (Click here for background on the CFTC's new authority in the Federal Register Release adopting CFTC Rule 180.1. Click here, however, to access a discussion regarding a challenge to the CFTC’s position regarding its new authority in the article “California Federal Court Dismissal of CFTC Monex Enforcement Action Upsets Stable Legal Theories” in the May 6, 2018 edition of Bridging the Week. The Monex decision is currently on appeal. )
However, even if it was able to apply its new authority, the CFTC most likely would have lost an enforcement action against defendants premised on the facts of this case. Although under its Dodd-Frank fraud-based anti-manipulation authority the CFTC does not have to prove that a price or market effect existed to prevail in a manipulation claim, it still has to evidence an intent to create false prices or at least some type of recklessness which led or could have led to non-bona fide results. Here, however, the Court found that defendants solely intended to achieve legitimate prices. They placed bids relying on the public terms of the flawed Three-Month Contract that reflected their view of the contract’s true value. They did so with an intent to attract liquidity and effectuate execution and not to mislead others. Settlement prices that came about because of their activities reflected fully legitimate, not illegitimate, market activity, said the court.
In the court’s view, the CFTC simply did not present sufficient evidence to support its charges against defendants and “persisted in its cry of market manipulation based on little more than an ‘earth is flat’ style conviction that such manipulation must have happened because the market remained illiquid.” That strategy was not enough to sustain the CFTC’s case under its traditional manipulation authority and, in my view, would most likely not have been sufficient under its new, broader authority.