The Commodity Futures Trading Commission (“CFTC” or “Commission”) adopted two new regulations on July 7, implementing some, but not all, of the agency’s new anti-manipulation authority under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”). The new regulations set forth the standards under which the Commission will exercise its authority under section 6(c) of the Commodity Exchange Act (“CEA”), as amended by the Dodd-Frank Act, to prohibit and remedy “manipulative and deceptive devices and contrivances” as well as price manipulation more generally. Entities that violate these regulations will be subject to civil penalties of up to the greater of $1,000,000 or triple the monetary gain for each violation, as well as restitution of damages proximately caused by the violations.
The new regulations substantially reduce the CFTC’s burden of proving fraud and manipulation in the trading of physical commodities, futures, options and swaps and therefore should be of special concern to large, active traders in these markets. More worrisome for “swap dealers” and “major swap participants” is the separate anti-manipulation prohibition under amended CEA section 4s(h)(4)(A)(iii). That provision, which makes it unlawful for such entities “to engage in any act, practice, or course of business that is fraudulent, deceptive or manipulative,” mirrors language in the Investment Advisers Act of 1940 that has been held not to require proof of scienter. As such, this provision could potentially be used to prosecute allegedly misleading market conduct where there is no evidence of bad intent. The CFTC has signaled in its proposed rule that it intends to construe this provision broadly. A vote on the final rule has yet to be scheduled.1
1. Prohibition on Deceptive or Manipulative Devices or Contrivances
The first of the regulations issued by the CFTC on July 7 implements the Dodd-Frank provision making it “unlawful for any person, directly or indirectly, to use or employ, or attempt to use or employ, in connection with any swap, [physical commodity contract, or futures contract] any manipulative or deceptive device or contrivance” in contravention of rules to be established by the CFTC. The CFTC’s implementing regulation largely mirrors anti-manipulation rules promulgated by other enforcement agencies, including the SEC’s longstanding Rule 10b-5 (issued pursuant to Section 10(b) of the Securities Exchange Act of 1934), and similar regulations more recently issued by the FERC and the FTC. The CFTC explained in the preamble to the new regulations that it will be guided by precedent under Section 10(b) and Rule 10b-5 (given the similarity of the statutory language) but will not necessarily be “controlled” by that precedent in light of differences between securities markets and CFTC-regulated derivatives markets.
The first CFTC regulation prohibits intentional or reckless market manipulation. Market manipulation includes the actual or attempted use or employment of “any manipulative device, scheme, or artifice to defraud”; the actual or attempted making of untrue or misleading statements or omissions of material facts; actual or attempted fraud or deceit; and actual or attempted delivery of a “false or misleading or inaccurate report concerning crop or market information or conditions that affect or tend to affect the price of any commodity in interstate commerce.”2 The CFTC described the regulation as a “catch-all” prohibition on fraud and manipulation, and stated that the regulation will “be given a broad, remedial reading, embracing the use or employment, or attempted use or employment, of any manipulative or deceptive contrivance for the purpose of impairing, obstructing, or defeating the integrity of the markets subject to the jurisdiction of the Commission.”
This regulation should make it easier for the CFTC to prove market manipulation than was the case under pre-Dodd-Frank law. One important change is that the new regulation does not require the CFTC to prove that the alleged bad actor engaged in conduct with the specific intent to create an “artificial price,” defined under CFTC and judicial precedent as a price that does not reflect the “legitimate” forces of supply and demand. This “artificial price” requirement under section 9(a)(2) has long proved a major obstacle to the CFTC’s ability to successfully prosecute “perfected” and attempted manipulation cases. But under the new regulation, the CFTC need not show any intended market effect from the conduct in question, or that the accused had the ability to move the market price, or that the accused’s conduct caused movement in the market price. All that is required under the regulation is proof of fraud or deception that touches on market activity. The jettisoning of the “artificial price” requirement in the regulation implementing amended CEA section 6(c)(1) should make it possible for the CFTC to prosecute more cases involving alleged market manipulation.
In accordance with precedent under Rule 10b-5, the Commission announced that a person must act with scienter to violate the “catch-all” regulation implementing amended CEA section 6(c)(1). Scienter can be established by demonstrating intentional or reckless behavior; negligence or gross negligence will be insufficient. As is the case with the CFTC’s existing anti-manipulation authority, it will not be necessary for the Commission to prove reliance, loss causation or damages in order to establish a violation. The CFTC explained that those are elements of a private cause of action and are not necessary where the Commission is acting to protect the public interest and prevent manipulative behavior. In other words, harm to the regulatory scheme itself, even if no third party is adversely affected, will be enough to constitute a violation.
Amended CEA section 6(c)(1) prohibits deception and manipulation “in connection with” market activity. In the preamble to the final regulations, the Commission explained that it intends to interpret this language “broadly, not technically or restrictively.” It cited as “particularly instructive” 10b-5 case law holding that the phrase “in connection with” requires a nexus between fraudulent conduct and a securities transaction.
The Commission’s regulation emphasizes that attempted manipulation is prohibited under amended section 6(c)(1) of the CEA and the CFTC regulations.3 An attempt may be found where there is both the requisite intent and an overt act in furtherance of that intent. The Commission announced that it will assess the materiality of manipulative acts or omissions on a case-by-case basis, and will be guided by an objective “reasonable person” standard. In other words, the materiality standard will be satisfied if the conduct in question would likely affect the behavior of a reasonable market participant.
2. Prohibition on "Price Manipulation"
The second regulation adopted by the CFTC implements amended section 6(c)(3) of the CEA, which states that “[i]n addition to paragraph 1 [the “catch-all” provision described above], it shall be unlawful for any person, directly or indirectly, to manipulate or attempt to manipulate the price of any swap, or of any commodity in interstate commerce, or for future delivery on or subject to the rules of any registered entity.” The CFTC’s regulation parrots the language of the statute and makes clear that CEA section 9(a)(2) precedent will apply to amended CEA section 6(c)(3).4
Under amended CEA section 6(c)(3) and the CFTC’s implementing regulation, the Commission will continue to apply the pre-Dodd-Frank test for identifying “perfected” manipulation, which requires the Commission to establish that the accused had the ability to influence market prices, that it had the specific intent to create an artificial price, and that it engaged in conduct that caused artificial prices. The preamble to the regulation states that the Commission may conclusively presume an illegal effect on prices from the “nature of the conduct in question and other factual circumstances not requiring economic analysis.” Moreover, according to the CFTC, the conduct in question need not itself be intrinsically fraudulent or otherwise illegal in order to violate amended CEA section 6(c)(3) and the Commission’s implementing regulation. This commentary appears to be a direct response to the decision in United States v. Radley, 653 F.Supp.2d 803 (S.D. Tex. 2009), which dismissed an indictment charging violations of CEA section 9(a)(2) in part because the conduct in question involved otherwise lawful open market trading.
The CFTC’s new regulations mark a significant expansion of its authority to investigate and punish alleged acts of market manipulation, particularly in light of the fact that the Commission need not satisfy the “artificial price” requirement in order to prove a violation of the regulation implementing amended CEA section 6(c)(1).
3. Special Anti-Manipulation Provision Applicable to Swap Dealers and Major Swap Participants
Though not the subject of the regulations issued on July 7 by the CFTC, the Dodd-Frank Act contains yet another anti-manipulation provision aimed specifically at swap dealers and major swap participants. The legislation contains a section that specifically prohibits fraud and deceit by swap dealers and major swap participants in their business dealings with “Special Entities” (essentially federal agencies, state and local governments, pension funds and endowments). But within that section is a provision (amended CEA section 4s(h)(4)(A)(iii)) that makes it “unlawful for a swap dealer or major swap participant . . . to engage in any act, practice, or course of business that is fraudulent, deceptive or manipulative.” In its proposed rule implementing amended CEA section 4s(h), the CFTC clearly stated that it does not view that provision as limited to swap dealers’ and major swap participants’ dealings with Special Entities. See 75 Fed. Reg. 80638, 80642 (Dec. 22, 2010). Moreover, the CFTC noted that the language of amended CEA section 4s(h)(4)(A)(iii) “mirrors the language in Section 206(4) of the Investment Advisors Act of 1940 . . . which does not require scienter to prove liability,” citing to SEC v. Steadman, 967 F.2d 636, 647 (D.C. Cir. 1992). The CFTC thus has clearly signaled that it intends to interpret amended CEA section 4s(h)(4)(A)(iii) in a similar manner. This would potentially allow the CFTC to prosecute “constructive frauds” and conduct that operates as a fraud or deception, irrespective of whether the actor intended to defraud, deceive or manipulate. If the CFTC adheres in its final rule to the position signaled in its rule proposal, amended CEA section 4s(h)(4)(A)(iii) could wind up as the agency’s weapon of choice against swap dealers and major swap participants whom the agency believes to have engaged in harmful market activity.5
The CFTC has yet to announce when it will consider the final rule implementing amended CEA section 4s(h)(4)(A)(iii). Accordingly, while the regulations issued to date by the CFTC meaningfully enhance the agency’s enforcement authority, what is perhaps the most significant change to the agency’s anti-manipulation authority has yet to come.