On November 30, 2018, nearly two years after the trial concluded, the US District Court for the Southern District of New York found in favor of Defendants Donald R. Wilson (Wilson) and his derivatives trading firm DRW Investments, LLC (DRW) on all claims brought against them by the Commodity Futures Trading Commission (CFTC), namely, (1) market manipulation, (2) attempted market manipulation, and (3) control person liability. See CFTC v. Wilson and DRW Investments, LLC.

The CFTC alleged that Defendants attempted to manipulate, and in fact succeeded in manipulating, the IDEX USD Three-Month Interest Rate Swap Futures (IDEX Contract) market in submitting multiple bids during the IDEX Contract’s “settlement window” over a seven-month period in 2011 to affect the settlement price of the IDEX Contract and consequently the variation margin DRW received from its counterparties on its open positions in the IDEX Contract. Consistent with the court’s sharp questioning of the CFTC during its closing argument, the court made clear that the CFTC failed in its burden of proof, basing its claims on “little more than an ‘earth is flat’ – style conviction that manipulation must have happened because the market remained illiquid.” CFTC Chairman Christopher Giancarlo issued a press release stating that the CFTC was reviewing the court’s decision and considering next steps.

Background. The CFTC’s claims involved the exchange-traded IDEX Contract listed by the International Derivatives Clearinghouse (IDCH). Under the terms of the IDEX Contract, the “long” counterparty paid a fixed rate and the “short” counterparty paid a floating rate based on the three-month LIBOR rate. When interest rates were higher, the long counterparty received payments from the short counterparty (i.e., variation margin) based on the daily settlement rates of the IDEX Contract, which was determined by a variety of factors, including (1) the midpoint of the electronically submitted bids and offers that were open between 2:45 and 3:00 PM EST, or the PM Settlement Period, (2) the settlement price of trades consummated during the PM Settlement Period, and (3) the prevailing interest rates in corresponding contracts in the over-the-counter (OTC) swaps markets (Corresponding OTC Rates).

Wilson believed that the market for uncleared interest rate swaps would migrate into exchange-traded, centrally cleared contracts, and that the IDEX Contract was mispriced in relation to the OTC swap rate (i.e., the IDEX Contract’s fair market value was significantly higher than that of comparable OTC swaps), thereby creating an arbitrage opportunity. By the end of September 2010, DRW came to acquire a net long position with a notional value of more than $300 million in the IDEX Contract. Over the course of a seven-month period beginning in January 2011, in an attempt to increase the settlement price of the IDEX Contract and consequently the variation margin DRW received from its counterparties on its open positions in the IDEX Contract, DRW placed numerous electronic bids for the IDEX Contract during the PM Settlement Period that were above the Corresponding OTC Rates. While none of DRW’s bids were accepted, DRW maintained that it desired to transact at the submitted bid prices, and its bids contributed to price discovery in an illiquid market.

The CFTC claimed that DRW attempted to manipulate, and in fact succeeded in manipulating, the IDEX Contract market because DRW intended to affect the price of the IDEX Contract to benefit DRW’s long position in the IDEX Contract.

Court’s Decision. The court held that the CFTC failed in its claims of market manipulation and attempted market manipulation because it offered no proof to demonstrate that Defendants caused an artificial price (i.e., caused the settlement price of the IDEX Contract to be inflated or above fair market value). In other words, the court rejected the CFTC’s underlying argument that the Defendants’ intent to affect the IDEX Contract settlement price was sufficient in establishing a key element of a manipulation claim—artificial price. The court believed that DRW’s trading strategy was supported by legitimate economic rationale, and enumerated the following gaps, “concessions almost,” in the CFTC’s case: (1) no evidence that DRW ever made a bid that it thought might be unprofitable; (2) no credible evidence that DRW ever made a bid that it thought could not be accepted by a counterparty; (3) no credible evidence proffered by the CFTC to establish the fair value of the IDEX Contract at the time DRW submitted its bids; (4) no credible evidence that DRW’s bidding practices “scared off” potential market participants; and (5) no evidence that DRW made a bid that violated any IDCH rule.

In ruling against the CFTC on its attempted manipulation claim, the court relied on a standard for attempted manipulation that it had determined earlier in the case, namely, that the intent to affect a price is an insufficient standard of proof. Rather, the CFTC had to “show that Defendants intended to cause an artificial price.” As the CFTC acknowledged, because the “Defendants made bids with an honest desire to transact at those posted prices,” there was no liability for attempted manipulation.

Given the Court found the CFTC failed in its market manipulation and attempted manipulation claims, it found in favor of Wilson on the CFTC’s control person and aiding and abetting claims, as such claims required an underlying violation of manipulation or attempted manipulation.

Conclusion. The CFTC brought its price manipulation claims against Defendants pursuant to its authority under Sections 6(c) and 9(a)(2) of the Commodity Exchange Act, which were subsequently expanded under the Dodd-Frank Act to encompass fraud-based manipulation with a lower intent standard of recklessness. However, even under its new enforcement authority, the CFTC likely would have failed in a fraud-based manipulation claim against Defendants, as the court’s findings of fact indicate that the CFTC would not be able to prove that Defendants had an intent to defraud, or acted recklessly in defrauding, the market.